**UNITEDSTATES********SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark  One)**                                                                                                                                                 |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                                      | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE********SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                      |
| **For the quarterly period ended March 31, 2005**                                                                                                          |
| ** **                                                                                                                                                      |
| **OR**                                                                                                                                                          |
| **o**                                                                                                                                                           | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE********SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                      |
| **For the transition period from            to           ** |
| ** **                                                                                                                                                      |
| **COMMISSION FILE NUMBER 000-29661**                                                                                                                            |

 

**UTSTARCOM, INC.**

(Exactname of registrant as specified in its charter)

 
| **DELAWARE**                                                                      | ** ** | **52-1782500**                        |
|-----------------------------------------------------------------------------------|------------|---------------------------------------|
| (State  of Incorporation)                                                         |       | (I.R.S.  Employer Identification No.) |
| **1275 HARBOR BAY PARKWAY****ALAMEDA,  CALIFORNIA**                               | ** ** | **94502**                             |
| (Address  of principal executive offices)                                         |       | (zip  code)                           |
| Registrant’s  telephone number, including area code: **(510) 864-8800** |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes    ý  No   o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).  Yes   ý   No  o

 

As of May 5, 2005 therewere 114,841,986 shares of the registrant’s common stock outstanding, par value$0.00125.

 

 

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**TABLE OFCONTENTS**

 
| PART I—FINANCIAL  INFORMATION | 3                                                                                                        |
|-----------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                    |                                                                                                     |   |
|                                    | ITEM  1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                                 | 3 |
|                                    |                                                                                                     |   |
|                                    | ITEM  2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS | 29 |
|                                    |                                                                                                     |   |
|                                    | ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES  ABOUT MARKET RISKS                                 | 57 |
|                                    |                                                                                                     |   |
|                                    | ITEM 4—CONTROLS AND PROCEDURES                                                                      | 58 |
|                                    |                                                                                                     |   |
| PART II—OTHER INFORMATION     | 68                                                                                                       |
|                                    |                                                                                                     |   |
|                                    | ITEM 1—LEGAL PROCEEDINGS                                                                            | 68 |
|                                    |                                                                                                     |   |
|                                    | ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES  AND USE OF PROCEEDS                                 | 70 |
|                                    |                                                                                                     |   |
|                                    | ITEM 3—DEFAULTS UPON SENIOR SECURITIES                                                              | 70 |
|                                    |                                                                                                     |   |
|                                    | ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF  SECURITY HOLDERS                                         | 70 |
|                                    |                                                                                                     |   |
|                                    | ITEM 5 —OTHER INFORMATION                                                                           | 70 |
|                                    |                                                                                                     |   |
|                                    | ITEM 6—EXHIBITS                                                                                     | 70 |
|                                    |                                                                                                     |   |
|                                    | Signatures                                                                                               |   |
|                                    |                                                                                                     |   |

 

2

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**PART I—FINANCIAL INFORMATION**

 

**ITEM 1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**UTSTARCOM, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

 

**(In thousands, except share and per share data)**

 
| ** **                                                                                                                                                                              | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                                              |       |               |       |                  |       |
| Current assets:                                                                                                                                                                         |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                               |       | $                  | 372,714    |                  | $          | 562,532 |   |
| Short-term investments                                                                                                                                                                  |       | 16,224             |       | 136,283               |       |
| Accounts receivable, net of allowances for  doubtful accounts                                                                                                                           |       | 740,430            |       | 719,625               |       |
| Accounts receivable, related parties                                                                                                                                                    |       | 166,679            |       | 86,988                |       |
| Notes receivable                                                                                                                                                                        |       | 22,926             |       | 26,982                |       |
| Inventories                                                                                                                                                                             |       | 601,717            |       | 590,832               |       |
| Deferred costs/Inventories at customer  sites under contracts                                                                                                                           |       | 182,922            |       | 198,155               |       |
| Prepaids                                                                                                                                                                                |       | 78,425             |       | 112,525               |       |
| Current deferred taxes                                                                                                                                                                  |       | 141,358            |       | 143,123               |       |
| Short-term restricted cash and investments                                                                                                                                              |       | 29,551             |       | 33,347                |       |
| Other current assets                                                                                                                                                                    |       | 31,362             |       | 42,058                |       |
| Total current assets                                                                                                                                                                    |       | 2,384,308          |       | 2,652,450             |       |
| Property, plant and equipment, net                                                                                                                                                      |       | 278,487            |       | 268,759               |       |
| Long-term investments                                                                                                                                                                   |       | 35,131             |       | 35,590                |       |
| Goodwill                                                                                                                                                                                |       | 195,816            |       | 180,627               |       |
| Intangible assets, net                                                                                                                                                                  |       | 94,438             |       | 98,211                |       |
| Other long-term assets                                                                                                                                                                  |       | 78,872             |       | 80,368                |       |
| Total assets                                                                                                                                                                            |       | $                  | 3,067,052  |                  | $          | 3,316,005 |   |
|                                                                                                                                                                                    |       |               |       |                  |       |
| **LIABILITIES,  MINORITY INTEREST AND STOCKHOLDERS’ EQUITY**                                                                                                                       |       |               |       |                  |       |
| Current liabilities:                                                                                                                                                                    |       |               |       |                  |       |
| Accounts payable                                                                                                                                                                        |       | $                  | 440,706    |                  | $          | 407,536 |   |
| Short-term debt                                                                                                                                                                         |       | 275,485            |       | 351,183               |       |
| Income taxes payable                                                                                                                                                                    |       | 111,812            |       | 143,778               |       |
| Customer advances                                                                                                                                                                       |       | 93,049             |       | 323,938               |       |
| Deferred revenue                                                                                                                                                                        |       | 97,134             |       | 66,941                |       |
| Other current liabilities                                                                                                                                                               |       | 236,523            |       | 241,577               |       |
| Total current liabilities                                                                                                                                                               |       | 1,254,709          |       | 1,534,953             |       |
|                                                                                                                                                                                    |       |               |       |                  |       |
| Convertible subordinated notes                                                                                                                                                          |       | 402,500            |       | 410,655               |       |
| Total liabilities                                                                                                                                                                       |       | 1,657,209          |       | 1,945,608             |       |
|                                                                                                                                                                                    |       |               |       |                  |       |
| Commitments and contingencies (Note 16)                                                                                                                                            |       |               |       |                  |       |
| Minority interest in consolidated  subsidiaries                                                                                                                                         |       | 5,604              |       | 5,025                 |       |
| Stockholders’ equity:                                                                                                                                                              |       |               |       |                  |       |
| Common stock: $0.00125 par value;  authorized: 750,000,000 shares; issued and outstanding: 114,841,986 and  114,486,632 at March 31, 2005 and December 31, 2004, respectively |       | 144                |       | 144                   |       |
| Additional paid-in capital                                                                                                                                                              |       | 1,123,826          |       | 1,123,065             |       |
| Deferred stock compensation                                                                                                                                                             |       | (5,527             | )          | (6,102                | )          |
| Retained earnings                                                                                                                                                                       |       | 281,458            |       | 243,452               |       |
| Accumulated other comprehensive income                                                                                                                                                  |       | 4,338              |       | 4,813                 |       |
| Total stockholders’ equity                                                                                                                                                         |       | 1,404,239          |       | 1,365,372             |       |
| Total liabilities, minority interest and  stockholders’ equity                                                                                                                     |       | $                  | 3,067,052  |                  | $          | 3,316,005 |   |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

3

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**UTSTARCOM, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

 

**(In thousands, except per share data)**

 
| ** **                                                                                | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                                                                      |       |                                  |       |   |   |
| Net sales                                                                                 |       |                                  |       |   |   |
| Unrelated party                                                                           |       | $                                     | 606,160    |   | $ | 610,731 |   |
| Related party                                                                             |       | 295,635                               |       | 11,561 |   |
|                                                                                      |       | 901,795                               |       | 622,292 |   |
| Cost of net sales                                                                         |       |                                  |       |   |   |
| Unrelated party                                                                           |       | 537,638                               |       | 441,527 |   |
| Related party                                                                             |       | 125,968                               |       | 4,731 |   |
| Gross profit                                                                              |       | 238,189                               |       | 176,034 |   |
| Operating expenses:                                                                       |       |                                  |       |   |   |
| Selling, general and administrative                                                       |       | 108,210                               |       | 66,943 |   |
| Research and development                                                                  |       | 66,660                                |       | 45,658 |   |
| Amortization of intangible assets                                                         |       | 6,972                                 |       | 2,973 |   |
| Total operating expenses                                                                  |       | 181,842                               |       | 115,574 |   |
|                                                                                      |       |                                  |       |   |   |
| Operating income                                                                          |       | 56,347                                |       | 60,460 |   |
|                                                                                      |       |                                  |       |   |   |
| Interest income                                                                           |       | 1,349                                 |       | 1,354 |   |
| Interest expense                                                                          |       | (4,278                                | )          | (1,082 | ) |
| Other income (expense), net                                                               |       | (6,847                                | )          | 8,785 |   |
| Income before income taxes, minority  interest and equity in loss of affiliated companies |       | 46,571                                |       | 69,517 |   |
| Income tax expense                                                                        |       | (7,884                                | )          | (13,704 | ) |
| Minority interest in earnings of  consolidated subsidiaries                               |       | (222                                  | )          | (50 | ) |
| Equity in loss of affiliated companies                                                    |       | (459                                  | )          | (997 | ) |
| Net income                                                                                |       | $                                     | 38,006     |   | $ | 54,766 |   |
|                                                                                      |       |                                  |       |   |   |
| Earnings per share - Basic                                                                |       | $                                     | 0.33       |   | $ | 0.48 |   |
| Earnings per share - Diluted                                                              |       | $                                     | 0.29       |   | $ | 0.40 |   |
|                                                                                      |       |                                  |       |   |   |
| Weighted average shares used in per-share  calculation:                                   |       |                                  |       |   |   |
| - Basic                                                                                   |       | 114,523                               |       | 114,614 |   |
| - Diluted                                                                                 |       | 132,949                               |       | 139,325 |   |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

4

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** **

**UTSTARCOM, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

 

**(In thousands)**

 
| ** **                                                                     | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                          |       |                                  |       |   |   |
| Net income                                                                     |       | $                                     | 38,006     |   | $ | 54,766 |   |
| Adjustments to reconcile net income to net  cash used in operating activities: |       |                                  |       |   |   |
| Depreciation and amortization                                                  |       | 25,897                                |       | 16,438 |   |
| Net loss on sale of assets                                                     |       | 1,278                                 |       | 190 |   |
| Amortization of debt issuance costs                                            |       | 583                                   |       | 582 |   |
| Warrants adjustment to fair value                                              |       | —                                |       | 226 |   |
| Net gain on long-term investments                                              |       | —                                |       | (34 | ) |
| Stock compensation expense                                                     |       | 575                                   |       | 77 |   |
| Provision for doubtful accounts                                                |       | 17,548                                |       | 6,252 |   |
| Inventory provision                                                            |       | 15,160                                |       | 9,439 |   |
| Equity in loss of affiliated companies                                         |       | 459                                   |       | 997 |   |
| Deferred income taxes                                                          |       | 505                                   |       | (2,236 | ) |
| Minority interest in earnings of  consolidated subsidiary                      |       | 222                                   |       | 50 |   |
| Changes in operating assets and  liabilities, net of effects of acquisition:   |       |                                  |       |   |   |
| Accounts receivable                                                            |       | (118,193                              | )          | (69,862 | ) |
| Inventories                                                                    |       | (15,724                               | )          | (70,480 | ) |
| Deferred costs/Inventories at customer  sites under contracts                  |       | 2,679                                 |       | 132,737 |   |
| Other current and non-current assets                                           |       | 49,653                                |       | (13,279 | ) |
| Accounts payable                                                               |       | 33,429                                |       | 36,841 |   |
| Income taxes payable                                                           |       | (31,843                               | )          | 12,479 |   |
| Customer advances                                                              |       | (227,854                              | )          | (156,399 | ) |
| Deferred revenue                                                               |       | 30,211                                |       | 12,251 |   |
| Other current liabilities                                                      |       | (5,468                                | )          | 1,671 |   |
| Net cash used in operating activities                                          |       | (182,877                              | )          | (27,294 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                          |       |                                  |       |   |   |
| Additions to property, plant and equipment                                     |       | (28,313                               | )          | (27,740 | ) |
| Investment in affiliates, net of cash  acquired                                |       | —                                |       | (1,000 | ) |
| Purchase of business                                                           |       | (18,449                               | )          | — |   |
| Proceeds from disposal of property                                             |       | 482                                   |       | — |   |
| Purchase of technology licenses                                                |       | (500                                  | )          | (125 | ) |
| Change in restricted cash                                                      |       | 5,796                                 |       | (58 | ) |
| Purchase of short-term investments                                             |       | (101,194                              | )          | (50,575 | ) |
| Proceeds from sale of short-term  investments                                  |       | 221,253                               |       | 51,460 |   |
| Net cash provided by (used in) investing  activities                           |       | 79,075                                |       | (28,038 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                          |       |                                  |       |   |   |
| Issuance of stock, net of expenses                                             |       | 667                                   |       | 9,224 |   |
| Net proceeds from borrowing                                                    |       | 146,000                               |       | — |   |
| Repayments of borrowings                                                       |       | (230,000                              | )          | — |   |
| Repurchase of stock                                                            |       | —                                |       | (78,155 | ) |
| Proceeds from equity offering                                                  |       | —                                |       | 474,554 |   |
| Net cash provided by (used in) financing  activities                           |       | (83,333                               | )          | 405,623 |   |
| Effect of exchange rate changes on cash                                        |       | (2,683                                | )          | 674 |   |
| Net increase (decrease) in cash and cash  equivalents                          |       | (189,818                              | )          | 350,965 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                              |       | 562,532                               |       | 377,747 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                     |       | $                                     | 372,714    |   | $ | 728,712 |   |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

5

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** **

**UTSTARCOM, INC.**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

 

**1.                             BASIS OFPRESENTATION:**

 

The accompanying unauditedcondensed consolidated financial statements include the accounts of UTStarcom, Inc.(the “Company”) and its wholly and majority owned subsidiaries. All significantintercompany accounts and transactions have been eliminated in the preparationof the condensed consolidated financial statements. The minority interests inconsolidated subsidiaries and equity in affiliated companies are shownseparately in the condensed consolidated financial statements.  The Company also consolidates variableinterest entities (“VIE”) as defined by Financial Accounting Standards BoardInterpretation No. 46 (“FIN 46”) “Consolidation of Variable InterestEntities” where the Company is the primary beneficiary.  Investments in affiliated companies areaccounted for using the cost or equity method, as applicable.

 

The accompanying financialstatements as of March 31, 2005 and for the three months ended March 31,2005 and 2004 have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission (the “SEC”). Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations. The December 31,2004 balance sheet was derived from audited financial statements, but does notinclude all disclosures required by generally accepted accounting principles.These condensed consolidated financial statements should be read in conjunctionwith the Company’s audited December 31, 2004 financial statements,including the notes thereto, and the other information set forth in the Company’sAnnual Report on Form 10-K for the year ended December 31,2004.

 

In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements reflect all adjustments (consisting of only normal recurring adjustments)considered necessary for a fair statement of the Company’s financial condition,the results of its operations and its cash flows for the periods indicated. Theresults of operations for the three months ended March 31, 2005 are notnecessarily indicative of the operating results for the full year.

 

**2.                             REVENUERECOGNITION:**

 

Revenues from sales oftelecommunications equipment and handsets are recognized when persuasiveevidence of an arrangement exists, delivery of the product has occurred,customer acceptance has been obtained, the fee is fixed or determinable andcollectability is reasonably assured. If the payment due from the customer isnot fixed or determinable due to extended payment terms, revenue is recognizedas payments become due from the customer, assuming all other criteria forrevenue recognition are met. Any payments received prior to revenue recognitionare recorded as customer advances. Normal payment terms differ for variousreasons amongst different customer regions, depending upon common businesspractices for customers within a region. Shipping and handling costs arerecorded as revenues and costs of revenues. Any expected losses on contractsare recognized when identified.

 

Sales may be generatedfrom complex contractual arrangements that require significant revenuerecognition judgments, particularly in the areas of multiple elementarrangements. Where multiple elements exist in an arrangement, the arrangementfee is allocated to the different elements based upon verifiable objectiveevidence of the fair value of the elements, as governed under Emerging IssuesTask Force Issue (“EITF”) No. 00-21, and SEC Staff AccountingBulletin No. 104 (“SAB 104”). Multiple element arrangements primarilyinvolve the sale of Personal Access Systems (“PAS”), a family of wirelessaccess handsets, wireless consumer products and core infrastructure equipmentor Internet Protocol-based PAS, (“iPAS”), wireless access systems that employmicro cell radio technology and specialized handsets, allowing serviceproviders to offer subscribers both mobile and fixed access to telephoneservices. These multiple element arrangements include the sale of PAS or iPASequipment with handsets, installation and training and the provision of suchequipment to different locations for the same customer. Revenue is recognizedas each element is earned, namely upon installation and acceptance of equipmentor delivery of handsets, provided that the fair value of the undeliveredelement(s) has been determined, the delivered element(s) hasstand-alone value, there is no right of return on delivered element(s), and theCompany is in control of the undelivered element(s). For arrangements thatinclude service elements, including promotional support and installation, forwhich verifiable objective evidence of fair value does not exist, revenue isdeferred until such services are deemed complete.

 

Final acceptance isrequired for revenue recognition when installation services are not consideredperfunctory. Final acceptance indicates that the customer has fully accepteddelivery of equipment and the Company is entitled to the full payment. TheCompany will not recognize revenue before final acceptance is granted by thecustomer if acceptance is considered substantive to the transaction.Additionally, the Company does not recognize revenue when cash payments arereceived from customers for transactions

 

6

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that do not have thecustomer’s final acceptance. The Company records these cash receipts ascustomer advances, and defers revenue recognition until final acceptance isreceived.

 

Where multiple elementsexist in an arrangement that includes software, and the software is consideredmore than incidental to the equipment or services in the arrangement, softwareand software related elements are recognized under the provisions of Statementof Position 97-2, as amended, and EITF No. 03-05. The Companyallocates revenues to each element of software arrangements based on vendorspecific objective evidence (“VSOE”). VSOE of each element is based on theprice charged when the same element is sold separately. The Company uses theresidual method to recognize revenue when an arrangement includes one or moreelements to be delivered at a future date and VSOE of the fair value of all theundelivered elements exists. Under the residual method, the fair value of theundelivered elements is deferred and the remaining portion of the arrangementfee is recognized as revenue. If evidence of fair value of one or moreundelivered elements does not exist, revenue is deferred and recognized whendelivery of those elements occurs or when fair value can be established.

 

The Company recognizesrevenue for system integration, installation and training upon completion ofperformance and if all other revenue recognition criteria are met. Otherservice revenue, such as that related to maintenance and support contracts, isrecognized ratably over the contract term. Revenues from services were lessthan 10% of revenues for all periods.

 

The Company also sellsproducts through resellers. Revenue is generally recognized when the standardprice protection period, which ranges from 30 to 90 days, has lapsed. Ifcollectability cannot be reasonably assured in a reseller arrangement, revenueis recognized upon sell-through to the end customer and receipt of cash. Theremay be additional obligations in reseller arrangements such as inventoryrotation, or stock exchange rights on the product. As such, revenue isrecognized in accordance with Statement of Financial Accounting Standards No. 48,“Revenue Recognition When Right of Return Exists,” (“SFAS 48”). The Company hasdeveloped reasonable estimates for stock exchanges. Estimates are derived basedon historical experience with similar types of sales of similar products.

 

The Company has salesagreements with certain wireless customers that provide for a rebate of theselling price to such customers if the particular product is subsequently soldat a lower price to such customers or to a different customer. The rebateperiod extends for a relatively short period of time. Historically, the amountsof such rebates paid to customers have not been material. The Company estimatesthe amount of the rebate based upon the terms of each individual arrangement,historical experience and future expectations of price reductions, and theCompany records its estimate of the rebate amount at the time of the sale. TheCompany also enters into sales incentive programs, such as co-marketingarrangements, with certain wireless and handset customers. The Company recordsthe incurred incentive as a reduction of revenue when the sales revenue isrecognized.

 

The assessment ofcollectability is also a factor in determining whether revenue should berecognized. The Company assesses collectability based on a number of factors,including payment history and the credit worthiness of the customer. TheCompany does not request collateral from its customers. In international sales,the Company often requires letters of credit from its customers that can bedrawn on demand if the customer defaults on its payment. If the Companydetermines that collection of a payment is not reasonably assured, the Companyrecognizes revenue at the time collection becomes reasonably assured, which isgenerally upon receipt of cash. Occasionally, the Company enters into revenuesharing arrangements. Under these arrangements, the Company collects revenuesonly after its customer, the telecommunications service provider, collectsservice revenues. When the Company enters a revenue sharing arrangement, theCompany does not recognize revenue until collection is reasonably assured.

 

Because of the nature ofdoing business in China and other emerging markets, the Company’s billingsand/or customer payments may not correlate with the contractual payment termsand the Company generally does not enforce contractual payment terms prior tofinal acceptance. Accordingly, accounts receivable are not booked until theCompany recognizes the related customer revenue. Advances from customers arerecognized when the Company has collected cash from the customer, prior torecognizing revenue. Deferred revenue is recorded if there are undeliveredelements after final acceptance has been obtained.

 

**3.                             EARNINGS PER SHARE:**

 

Basic earnings per share iscomputed by dividing net income available to holders of common stock by theweighted average number of shares of the Company’s common stock outstandingduring the period. Diluted earnings per share is determined by adjusting netincome as reported by the effect of dilutive securities and increasing thenumber of shares by potentially dilutive shares of common stock outstandingduring the period. Potentially dilutive shares of common stock consist ofemployee stock options, a written call option, warrants, convertiblesubordinated notes and unvested acquisition-related stock options.

 

The following is a summaryof the calculation of basic and diluted earnings per share (in thousands,except per share data):

 

7

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| ** **                                                           | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                           | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                                                 |       |                                  |       |   |   |
| Numerator:                                                           |       |                                  |       |   |   |
|                                                                 |       |                                  |       |   |   |
| Net income (for basic EPS computation)                               |       | $                                     | 38,006     |   | $ | 54,766 |   |
|                                                                 |       |                                  |       |   |   |
| Effect of Dilutive Securities                                        |       |                                  |       |   |   |
| Interest expense on 7/8% Convertible  Subordinated Notes, net of tax |       | 951                                   |       | 917 |   |
|                                                                 |       |                                  |       |   |   |
| Net income adjusted for dilutive securities                          |       | $                                     | 38,957     |   | $ | 55,683 |   |
|                                                                 |       |                                  |       |   |   |
| Denominator:                                                         |       |                                  |       |   |   |
|                                                                 |       |                                  |       |   |   |
| Shares used to compute basic EPS                                     |       | 114,523                               |       | 114,614 |   |
| Dilutive common stock equivalent shares:                             |       |                                  |       |   |   |
| Stock options                                                        |       | 1,157                                 |       | 6,326 |   |
| Written call option                                                  |       | —                                |       | 1,046 |   |
| Conversion of convertible subordinated  notes                        |       | 16,919                                |       | 16,919 |   |
| Warrants                                                             |       | —                                |       | 30 |   |
| Unvested acquisition-related stock                                   |       | 350                                   |       | 390 |   |
| Shares used to compute diluted EPS                                   |       | 132,949                               |       | 139,325 |   |
|                                                                 |       |                                  |       |   |   |
| Earnings per share - basic                                           |       | $                                     | 0.33       |   | $ | 0.48 |   |
| Earnings per share - diluted                                         |       | $                                     | 0.29       |   | $ | 0.40 |   |

 

Certain potential sharesrelated to employee stock options outstanding during the three months ended March 31,2005 and 2004 were excluded in the diluted per share computations, since theirexercise prices were greater than the average market price of the Company’scommon stock during the period and, accordingly, their effect is anti-dilutiveunder the treasury stock method. For the three months ended March 31, 2005and 2004, these shares totaled 15.4 million with a weighted averageexercise price of $24.09 per share and 1.6 million shares with a weightedaverage exercise price of $38.04 per share, respectively.

 

At March 31, 2005, theCompany’s 7/8% convertible subordinated notes outstanding were eligible forconversion into shares of common stock. For each $1,000 of aggregate principalamount of notes converted, the Company will deliver approximately 42.0345shares of common stock, if the Company’s closing stock price exceeds aspecified threshold as of the last trading day of the immediately precedingfiscal quarter. At December 31, 2004, the closing price of the Company’s common stock was below the specifiedthreshold. In September 2004, the EITF reached a consensus relatedto EITF No. 04-8 “The Effect of Contingently Convertible Debt onDiluted Earnings per Share.”  The consensus requires contingentlyconvertible debt instruments with a market price trigger to be treated the sameas traditional convertible debt instruments for purposes of computed earningsper share using the “if converted” method.  The EITF pronouncement iseffective and conversion is assumed in this diluted EPS computation.

 

The net income for thediluted EPS computation reflects the reduction in interest expense of $1.0 millionand $0.9 million, net of tax, for the three months ended March 31,2005 and 2004, respectively, that would result from an assumed conversion ofthe 7/8% convertible subordinated notes.

 

The Company entered intoconvertible bond hedge and call option transactions to reduce the potentialdilution from conversion of the notes. Both the bond hedge and call optiontransactions may be settled at the Company’s option either in cash or netshares and expire on March 1, 2008. Using the treasury stock method, under Statement of Financial AccountingStandards No. 128, “Earnings Per Share” (“SFAS 128”), this would have theeffect of decreasing the denominator for diluted earnings per share by 5.1 millionshares for the bond hedge transaction, and increasing the denominator fordiluted earnings per share by 1.0 million shares for the call optiontransaction.  However, only the dilutive effect of the 1.0 millionshares with respect to the call option transaction is included in the Company’sdiluted earnings per share calculation above.  The convertible bond hedge,under SFAS 128, is always anti-dilutive.

 

During the three monthsended March 31, 2005, the average price of the Company’s stock was belowthe specified strike prices of both the convertible bond hedge and call optiontransactions and, therefore, there was no dilutive effect*.* For the three months ended March 31,2004, the average price of the Company’s stock exceeded both the specifiedstrike prices of the convertible bond hedge and

 

8

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call option transactions and,therefore, the dilutive effect of the 1.0 million shares with respect tothe call option transaction is included in the diluted earnings per sharecalculation.

 

**4.                             STOCK-BASEDCOMPENSATION:**

 

The Company accounts foremployee stock option grants in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) andhas adopted the disclosure-only alternative of SFAS No. 123, as amended bySFAS No. 148, “Accounting for Stock-Based Compensation” (“SFAS 123”).Under APB 25, compensation expense is based on the difference, if any, on thedate of grant between the fair value of the common stock and the exercise priceof the option.

 

The fair value of warrants,options or stock exchanged for services from non-employees is expensed over theperiod benefited. The warrants and options are valued using the Black-Scholesoption pricing model.

 

The following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition provisions of SFAS 123 to stock-basedemployee compensation (in thousands, except per share data):

 
| ** **                                                                                                              | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                                                                                                    |       |                                  |       |   |   |
| Basic                                                                                                                   |       |                                  |       |   |   |
| Net income:                                                                                                             |       |                                  |       |   |   |
| As reported                                                                                                             |       | $                                     | 38,006     |   | $ | 54,766 |   |
| Add: Stock-based employee compensation  expense included in reported net income, net of related tax effects             |       | 409                                   |       | 55 |   |
| Deduct: Total compensation expense determined  under fair value based method for all awards, net of related tax effects |       | (6,278                                | )          | (7,966 | ) |
| Pro forma net income                                                                                                    |       | $                                     | 32,137     |   | $ | 46,855 |   |
|                                                                                                                    |       |                                  |       |   |   |
| Basic income per share:                                                                                                 |       |                                  |       |   |   |
| As reported                                                                                                             |       | $                                     | 0.33       |   | $ | 0.48 |   |
| Pro forma                                                                                                               |       | $                                     | 0.28       |   | $ | 0.41 |   |
|                                                                                                                    |       |                                  |       |   |   |
| Diluted                                                                                                                 |       |                                  |       |   |   |
| Net income:                                                                                                             |       |                                  |       |   |   |
| As reported                                                                                                             |       | $                                     | 38,006     |   | $ | 54,766 |   |
| Effect of dilutive securities 7/8%  Convertible subordinated notes                                                      |       | 951                                   |       | 917 |   |
| Add: Stock-based employee compensation  expense included in reported net income, net of related tax effects             |       | 409                                   |       | 55 |   |
| Deduct: Total compensation expense  determined under fair value method for all awards, net of related tax effects       |       | (6,278                                | )          | (7,966 | ) |
| Pro forma net income                                                                                                    |       | $                                     | 33,088     |   | $ | 47,772 |   |
|                                                                                                                    |       |                                  |       |   |   |
| Diluted income per share:                                                                                               |       |                                  |       |   |   |
| As reported                                                                                                             |       | $                                     | 0.29       |   | $ | 0.40 |   |
| Pro forma                                                                                                               |       | $                                     | 0.25       |   | $ | 0.35 |   |

 

9

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Thefollowing assumptions were used to calculate the fair values:

 
| ** **                               | ** ** | **Three months ended**  | ** ** |
|------------------------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
| **Stock Options:**                       |       |                    |       |   |   |
| Expected remaining term in years         |       | 3                       |       | 3 |   |
| Weighted average risk-free interest rate |       | 3.52%                   |       | 2.27% |   |
| Expected dividend rate                   |       | 0.00%                   |       | 0.00% |   |
| Volatility                               |       | 55.90%                  |       | 64.00% |   |

 

**5.                             COMPREHENSIVEINCOME:**

 

The reconciliation of netincome to comprehensive income for the three months ended March 31, 2005and 2004 is as follows (in thousands):

 
| ** **                                    | ** ** | **Three months ended March 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                          |       |                                  |       |   |   |
| Net income                                    |       | $                                     | 38,006     |   | $ | 54,766 |   |
| Unrealized loss on investments                |       | —                                |       | (233 | ) |
| Change in cumulative translation  adjustments |       | (475                                  | )          | 674 |   |
| Total comprehensive income                    |       | $                                     | 37,531     |   | $ | 55,207 |   |

 

**6.                             CASH, CASHEQUIVALENTS AND SHORT-TERM INVESTMENTS:**

 

Cash and cash equivalentsconsist of instruments with maturities of three months or less at the date ofpurchase. There were no available-for-sale securities included in cash and cashequivalents at March 31, 2005 or December 31, 2004. Short-terminvestments, consisting entirely of available-for-sale securities, were $16.2 millionand $136.3 million at March 31, 2005 and December 31, 2004, respectively.These available-for-sale securities consist of government-backed notes,commercial paper, floating rate corporate bonds and fixed income corporatebonds. These investments are recorded at fair value. Any unrealized holdinggains or losses are reported as a component of comprehensive other income.Realized gains and losses are reported in earnings.

 

The Company accepts banknotes receivable with maturity dates of between three and six months from itscustomers in China in the normal course of business.  The Company may discount these notes withbanking institutions in China. A sale of these notes is reflected as areduction of cash and cash equivalents or short-term investments and theproceeds of the settlement of these notes are included in cash flows fromoperating activities in the consolidated statement of cash flows. Bank notestotaling $56.9 million were sold during the three months ended March 31,2005 and none for the three months ended March 31, 2004. Any notesthat have been sold are not included in the Company’s consolidated balancesheets as the criteria for sale treatment established by Statement of FinancialAccounting Standards No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishment of Liabilities” (“SFAS 140”), havebeen met. Under SFAS 140, upon a transfer, the transferor or entity mustderecognize financial assets when control has been surrendered and thetransferee obtains control over the assets. In addition, the transferred assetshave been isolated from the transferor, beyond the reach of its creditors, andthe transferee has the right, without conditions or constraints, to pledge orexchange the assets it has received.  Thecost of settling these notes receivable was $0.5 million for the three monthsended March 31, 2005.

 

**7.                             SHORT-TERM********RESTRICTED CASH ANDINVESTMENTS:**

 

At March 31, 2005, theCompany had short-term restricted cash and investments of $29.6 millioncomprised of $21.3 million of restricted cash and $8.3 million ofrestricted short-term investments held for standby letters of credit and anescrow fund.  At December 31, 2004, the Company had restricted cashand short-term investments of $33.3 million primarily comprised of $24.3 millionof restricted cash and $8.6 million of restricted short-term investmentsfor standby letters of credit.

 

The Company issues standbyletters of credit primarily to support international sales activities outsideof China. When the Company

 

10

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submits a bid for a sale,often the potential customer will require that the Company issue a bid bond ora standby letter of credit to demonstrate its commitment through the bidprocess.  In addition, the Company may be required to issue standbyletters of credit as guarantees for advance customer payments upon contractsigning or performance guarantees. The standby letters of credit usually expiresix to nine months from date of issuance without being drawn by the beneficiarythereof. Finally, the Company may issue commercial letters of credit in supportof purchase commitments.

 

**8.                             ACCOUNTS AND NOTESRECEIVABLE:**

 

Allowances for doubtfulaccounts were $68.5 million and $51.2 million at March 31, 2005and December 31, 2004, respectively, for total accounts receivables, includingaccounts receivable from related parties.

 

The Company acceptscommercial notes receivable with maturity dates of between three and six monthsfrom its customers in China in the normal course of business. Notes receivableavailable for sale was $22.9 million and $27.0 million at March 31,2005 and December 31, 2004, respectively. The Company may discount thesenotes with banking institutions in China. A sale of these notes is reflected asa reduction of notes receivable and the proceeds of the settlement of thesenotes are included in cash flows from operating activities in the consolidatedstatement of cash flows.  Any notes thathave been sold are not included in the Company’s consolidated balance sheets asthe criteria for sale treatment established by SFAS 140, has been met. Therewere no notes receivable sold during the three months ended March 31, 2005and 2004.

 

**9.                             SUPPLEMENTALDISCLOSURES OF CASH FLOW INFORMATION:**

 
| ** **                       | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| **(in thousands)**               | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Cash paid during the period for: |       |                                  |       |   |   |
| Interest                         |       | $                                     | 5,104      |   | $ | 1,768 |   |
| Income taxes                     |       | $                                     | 1,489      |   | $ | 2,426 |   |

 
| ** **                                           | ** ** | **Three months ended March 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|
| **(in thousands)**                                   | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Non-cash operating activities were as  follows:      |       |                                  |       |   |   |
| Accounts receivable transferred to notes  receivable |       | $                                     | 9,394      |   | $ | 48,988 |   |
|                                                      |            |                                       |            |  |  |  |  |

 

**10.                          INVENTORIES**

 

As of March 31, 2005and December 31, 2004, total inventories consisted of the following:

 
| ** **                                       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| *Inventories*                                    |       |               |       |                  |       |
| Raw materials                                    |       | $                  | 137,159    |                  | $          | 154,977 |   |
| Work-in-process                                  |       | 47,252             |       | 65,551                |       |
| Finished goods                                   |       | 297,397            |       | 271,357               |       |
| Inventories at customer sites without  contracts |       | 119,909            |       | 98,947                |       |
|                                             |       | $                  | 601,717    |                  | $          | 590,832 |   |

 

**11.                          ACQUISITION**

 

*Giga*

 

On October 29, 2004,the Company entered into an asset purchase agreement with Giga Telecom, Inc.,(“Giga”), a Korean corporation

 

11

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that develops and designswireless handsets. The acquisition was intended to facilitate the Company’sexpansion into the CDMA handset market. The Company completed the acquisitionon January 4, 2005. At the closing, $13.0 million in cash was paid,and an additional $2.0 million was paid into an escrow account for sixmonths.  The total consideration for theacquisition, funded from cash on hand, was approximately $18.5 million,including $2.0 million in acquisition-related transaction costs and a $1.5 millionpayment made previously to be applied against the purchase price.  An earn-out of up to $2.0 million maybecome payable upon completion of certain product design milestones.  As of March 31, 2005, no milestones havebeen met and no contingent payment was accrued.

 

The following tablesummarizes the allocation of the purchase price for Giga based, in part, upon anindependent valuation (in thousands):

 
| Fair value of tangible net assets                                                               |   | $      | 458    |   |
|-------------------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Fair value of identified intangible assets:                                                     |   |   |   |
| Existing technology                                                                             |   | 1,200  |   |
| Pre-existing royalty agreement                                                                  |   | 1,920  |   |
| Excess of costs of acquiring Giga over fair  value of identified net assets acquired (goodwill) |   | 14,871 |   |
|                                                                                            |   |   |   |
|                                                                                            |   | $      | 18,449 |   |

 

The excess of the purchaseprice over the fair value of the identified net assets of approximately $14.9 millionwas allocated to goodwill and assigned to the handsets segment.  The goodwill created in this acquisitionresults from the decreased time to market and design related synergies.  This goodwill is tax deductible.

 

In accordance with EITF 04-1, “Accounting forPreexisting Relationships between the Parties to a Business Combination”, asettlement gain of $0.4 million relating to the pre-existing royaltyagreement was recognized and recorded under Research and Development expense inthe consolidated statements of operations. The purchased existing technology and pre-existing royalty agreementare to be amortized within a year.

 

The results of operations ofGiga have been integrated with the “handsets” segment and included in theCompany’s Consolidated Statement of Operations subsequent to theacquisition.  The pro forma effects ofthis acquisition on the Company’s financial statements are not significant.

 

*HSI*

 

The Companyrecorded a $2.2 million charge relating to the shut-down of the operationsof HSI, which the Company acquired in April 2004.  In the fourth quarter of 2004, the Companydecided to substantially abandon HSI’s legacy operation due to the difficultiesencountered in integrating the operations. The charge of $2.2 million includes fixed assets write-off, costsassociated with the termination of leases and personnel.

 

**12.                          GOODWILL ANDINTANGIBLE ASSETS:**

 

*Goodwill:*

 

As of March 31, 2005and December 31, 2004, goodwill was $195.8 million and $180.6 million,respectively.

 

Effective in the firstquarter of 2005, the Company realigned its business into five operating unitsand, accordingly, goodwill has been reallocated to the reporting units, using arelative fair value allocation approach prescribed in Statement of FinancialAccounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS142”).  See Note 18 for furtherdiscussion.  The Company determined therelative fair value of each reporting unit based, in part, upon an independentvaluation analysis.  The goodwillreallocation is reflected as follows.

 

12

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| **December 31, 2004**       | ** ** | **Goodwill**       | ** ** |
|----------------------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(in thousands)** | ** ** |
| China                            |       | $                  | 118,787    |   |
| International                    |       | 37,132             |       |
| Personal Communications Division |       | 24,708             |       |
| Total                            |       | $                  | 180,627    |   |

 
| **January 1, 2005**         | ** ** | **Goodwill**       | ** ** |
|----------------------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(in thousands)** | ** ** |
| Handsets                         |       | $                  | 74,003     |   |
| Wireless                         |       | 54,604             |       |
| PCD                              |       | 24,710             |       |
| Broadband                        |       | 23,210             |       |
| Service                          |       | 4,100              |       |
| Total                            |       | $                  | 180,627    |   |
| Giga selected assets acquisition |       | 14,871             |       |
| Effect of exchange rate changes  |       | 318                |       |
| **March 31, 2005**          |       | $                  | 195,816    |   |

 

 

13

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* *

*IntangibleAssets:*

 

As of March 31, 2005 and December 31,2004, intangible assets consisted of the following (in thousands): 

 
| ** **                     | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(in thousands)**             | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| Intangible assets:             |       |               |       |                  |       |
|                           |       |               |       |                  |       |
| Existing technology            |       | $                  | 40,756     |                  | $          | 39,530 |   |
| Less accumulated amortization  |       | (17,168            | )          | (14,933               | )          |
|                           |       | $                  | 23,588     |                  | $          | 24,597 |   |
|                           |       |               |       |                  |       |
| Customer relationships         |       | $                  | 57,220     |                  | $          | 57,220 |   |
| Less accumulated amortization  |       | (7,100             | )          | (5,455                | )          |
|                           |       | $                  | 50,120     |                  | $          | 51,765 |   |
|                           |       |               |       |                  |       |
| Supplier relationships         |       | $                  | 5,300      |                  | $          | 5,300 |   |
| Less accumulated amortization  |       | (1,104             | )          | (442                  | )          |
|                           |       | $                  | 4,196      |                  | $          | 4,858 |   |
|                           |       |               |       |                  |       |
| Trade names                    |       | $                  | 4,940      |                  | $          | 4,940 |   |
| Less accumulated amortization  |       | (1,417             | )          | (966                  | )          |
|                           |       | $                  | 3,523      |                  | $          | 3,974 |   |
|                           |       |               |       |                  |       |
| Backlog                        |       | $                  | 5,150      |                  | $          | 5,150 |   |
| Less accumulated amortization  |       | (3,283             | )          | (2,483                | )          |
|                           |       | $                  | 1,867      |                  | $          | 2,667 |   |
|                           |       |               |       |                  |       |
| Non-compete agreement          |       | $                  | 10,800     |                  | $          | 10,800 |   |
| Less accumulated amortization  |       | (1,125             | )          | $                     | (450       | ) |
|                           |       | $                  | 9,675      |                  | $          | 10,350 |   |
|                           |       |               |       |                  |       |
| Pre-existing royalty agreement |       | $                  | 1,960      |                  | $          | — |   |
| Less accumulated amortization  |       | (491               | )          | —                |       |
|                           |       | $                  | 1,469      |                  | $          | — |   |
|                           |       |               |       |                  |       |
| Total intangible assets        |       | $                  | 94,438     |                  | $          | 98,211 |   |

 

Amortization expense was $7.0 millionand $3.0 million for the three months ended March 31, 2005 and 2004,respectively.  The estimated aggregate amortization expense forintangibles for each of the five years from the year ended December 31,2006 through the year ended December 31, 2010 is $18.9 million, $16.0 million,$12.7 million, $6.9 million, $5.1 million and $15.7 millionthereafter.

 

The weighted averageamortization period for each class of unamortized identifiable intangibleassets include the following:

 
| **Intangible Asset Class**     | ** ** | **Weighted Average Life** | ** ** |
|--------------------------------|------------|---------------------------|------------|
| Technology                     |       | 3.6                       |       |
| Customer relationships         |       | 8.4                       |       |
| Supplier relationships         |       | 1.6                       |       |
| Trade names                    |       | 2.5                       |       |
| Backlog                        |       | 0.6                       |       |
| Non-compete                    |       | 3.6                       |       |
| Pre-existing royalty agreement |       | 0.9                       |       |
| Total                          |       | 5.2                       |       |

 

14

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**13.                          LONG-TERM INVESTMENTS:**

 

The Company’s investmentsare as follows (in thousands):

 

| ** **                    | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Softbank China                |       | $                        | 5,294      |                        | $          | 5,294 |   |
| Cellon International          |       | 8,000                    |       | 8,000                       |       |
| Restructuring Fund No. 1 |       | 2,402                    |       | 1,836                       |       |
| Global Asia Partners L.P.     |       | 1,150                    |       | 1,150                       |       |
| Fiberxon Inc.                 |       | 3,000                    |       | 3,000                       |       |
| Immenstar                     |       | 2,000                    |       | 2,000                       |       |
| Matsushita Joint Venture      |       | 6,935                    |       | 7,959                       |       |
| GCT SemiConductor             |       | 3,000                    |       | 3,000                       |       |
| Infinera                      |       | 1,902                    |       | 1,902                       |       |
| Others                        |       | 1,448                    |       | 1,449                       |       |
|                          |       |                     |       |                        |       |
| Total                         |       | $                        | 35,131     |                        | $          | 35,590 |   |

 

*SoftbankChina*

 

The Company has a $5.3 millioninvestment in Softbank China, an investment fund established by SOFTBANK CORP.focused on investments in Internet companies in China. This investment isintended to enable the Company to participate in the anticipated growth ofInternet-related businesses in China. SOFTBANK CORP. and its related companiesare significant stockholders of the Company. The Company’s investmentconstitutes 10% of the funding for Softbank China, with SOFTBANK CORP.contributing the remaining 90%. The fund has a separate management team, andnone of the Company’s employees are employed by the fund. Many of the fund’sinvestments are and will be in privately held companies, many of which arestill in the start-up or development stages. These investments are inherentlyrisky as the markets for the technologies or products the companies have underdevelopment are typically in the early stages and may never materialize. TheCompany accounts for this investment under the cost method. For additionalinformation regarding transactions with SOFTBANK CORP., refer to Note 19,Related Party Transactions. The Company did not record other than temporaryimpairment loss in the quarters ended March 31, 2005 and 2004.

 

*Cellon International*

 

In September 2001, theCompany invested $2.0 million in Cellon International Holdings Corporation(“Cellon”).  Cellon designs wireless terminals and related technology forhandset manufacturers and private distributors. The Company invested anadditional $3.0 million in each of April and December 2002. Asof March 31, 2005, the Company had a 9 % ownership interest in Cellon.This investment is accounted for under the cost method, and its carrying valueis evaluated for possible impairment based on the achievement of businessobjectives and milestones, the financial condition and prospects of the companyand other relevant factors. As of March 31, 2005, the Company has notrecorded any impairment of this investment. The Company has outstandingpurchase commitments with Cellon.  Foradditional information regarding transactions with Cellon, refer to Note 19,Related Party Transactions.

 

*RestructuringFund No. 1*

 

During fiscal 2002, theCompany invested $2.0 million in Restructuring Fund No. 1, a venturecapital investment limited partnership established by SOFTBANK INVESTMENTCORP., an affiliate of SOFTBANK CORP. SOFTBANK America Inc., an entityaffiliated with SOFTBANK CORP., is a significant stockholder of the Company.The fund focuses on leveraged buyout investments in companies in Asiaundergoing restructuring or bankruptcy procedures. The total fund offering isexpected to be between approximately $150.0 million and $226.0 million,with each investor contributing a minimum of $0.8 million. The fund has aseparate management team, and none of the Company’s employees are employed bythe fund. The Company accounts for this investment under the equity method ofaccounting.  The Company recorded $0.5 millionequity gain and insignificant equity losses for the three 

 

15

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months ended March 31,2005 and 2004, respectively.

 

*GlobalAsia Partners, L.P.*

 

In June 2002, theCompany invested $1.0 million in Global Asia Partners L.P., and anadditional $1.0 million in June 2003, with a commitment to invest upto a maximum of $5.0 million. The remaining amount is due at such timesand in such amounts as shall be specified in one or more future capital callsto be issued by the general partner. The fund size is anticipated to be $10.1 millionand the fund was formed to make private equity investments in private orpre-IPO technology and telecommunications companies. The fund’s geographicfocus is on technology investments in Asia, in particular in India and China.The Company accounts for this investment under the equity method ofaccounting.   No significant gains orlosses recorded during the three months ended March 31, 2005 and 2004.  In April 2005, the Company received a capitalcall in the amount of $0.5 million.

 

*FiberxonInc.*

 

In September 2002, theCompany invested $2.0 million in Fiberxon, Inc. (“Fiberxon”), acompany that develops and sells optical modules and related systems. In March 2004,the Company invested an additional $1.0 million in Fiberxon. Thisinvestment is accounted for under the cost method, and its carrying value isevaluated for possible impairment based on the achievement of businessobjectives and milestones, the financial condition and prospects of the companyand other relevant factors. As of March 31, 2005, the Company has notrecorded any impairment in respect of this investment. The Company hasoutstanding purchase commitments with Fiberxon. For additional informationregarding transactions with Fiberxon, refer to Note 19, Related PartyTransactions.

 

*ImmenStar*

 

On September 28, 2004,the Company invested $2.0 million in the Series A Preferred Stock ofImmenStar, Inc. (“ImmenStar”).  ImmenStar is a development stagecompany that is designing a chip which can be used in the Company’sproduct.  This investment is accounted for under the cost method and therewas no impairment loss recorded during the three months ended March 31,2005.

 

*MatsushitaJoint Venture*

 

In July, 2002, the Companyentered into a joint venture agreement with Matsushita Communication IndustrialCo., Ltd., a stockholder of the Company, to jointly design and develop,manufacture and sell telecommunication products. The Company has a 49%ownership interest in the joint venture company, which has a registered sharecapital of $10.0 million. The cash consideration of $4.9 millionpayable by the Company was paid in October 2002. As the Company does nothave voting control over significant matters of the joint venture company, theinvestment in and results of operations of the joint venture company are accountedfor using the equity method of accounting. The Company recorded equity losses of $1.0 million in each of thethree months ended March 31, 2005 and 2004.

 

During the fourth quarter of2004, the Company contributed an additional $9.3 million (its 49% of the$19 million capital call) to the joint venture.

 

*GCTSemiconductor*

 

In October 2004, theCompany invested $3.0 million in three million shares of GCTSemiconductor, Inc. (“GCT”) Series D Preferred Stock at $1.00 pershare. The investment represents approximately a 2% interest in the company,which designs, develops and markets integrated circuit solutions for thewireless communications industry. The investment is accounted for under thecost method and there was no impairment loss recorded during the three monthsended March 31, 2005 in relation to this investment.

 

*Infinera*

 

In July 2004, theCompany invested $3.0 million in 1,339,285 shares of Infinera Corporation(“Infinera”) Series D Preferred Stock at $2.24 per share.  Theinvestment represents an approximately 2% interest in Infinera, which developsoptical telecommunications 

 

16

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systems using photonicintegrated circuits.  This investment is accounted for under the costmethod.

 

In September 2004,Infinera closed a Series E Preferred Stock round at $0.60 per share. As a result of the close proximity between the Series D and Series Epreferred stock financing rounds and the decrease in the share price betweenrounds, Infinera and the Company entered into an exchange agreement whereby theCompany exchanged 669,643 shares of Series D preferred stock for 2,500,000shares of Series E preferred stock. After the exchange, the Company owns atotal of 669,643 shares of Series D and 2,500,000 shares of Series Epreferred stock.

 

There was no change in thecarrying amount as of March 31, 2005.

 

**14.                          DEBT:**

 

The following represents theoutstanding borrowings at March 31, 2005 and December 31, 2004 (inthousands):

 

| ** **                     | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Notes payable                  |       | $                        | 1,330      |                        | $          | 1,183 |   |
| Bank loans                     |       | 274,155                  |       | 358,155                     |       |
| Convertible subordinated notes |       | 402,500                  |       | 402,500                     |       |
| Total debt                     |       | $                        | 677,985    |                        | $          | 761,838 |   |
| Long-term debt                 |       | 402,500                  |       | 410,655                     |       |
| Short-term debt                |       | $                        | 275,485    |                        | $          | 351,183 |   |

 

Occasionally, the Companyissues short-term notes payable to its vendors in lieu of trade accountspayable.  The payment terms are normally three to nine months and aretypically non-interest bearing.  The Company had $1.3 million ofthese notes at March 31, 2005 included in short-term debt.

 

At March 31, 2005, theCompany has loans with various banks totaling $266.0 million with interestrates ranging from 3.04% to 4.35% per annum. These bank loans mature during 2005 and are included in short-term debt.

 

The Company has a bank loanin connection with an equipment purchase resulting from the consolidation ofMDC Holding Limited and its affiliated entities (“MDC”).  On January 10, 2003, a third partyestablished a bank loan with Shanghai Pudong Development Bank for the purchaseof the equipment.  The obligations of thebank loan and related equipment were assumed by the Company on January 23,2003, and subsequently transferred to MDC on December 31, 2003.  The bank loan of $8.2 million bearsinterest at a rate of 4.94% per annum, and expires on January 10,2006.  The Company does not serve aslegal obligor for the loan.

 

The Company has availableborrowing facilities of $487.5 million as of March 31, 2005. $480.3 millionof these facilities expire in 2005 and $7.2 million of these facilitiesexpire in 2010 with interest rates ranging from 3.04% to 4.35%. The Company hasnot guaranteed any debt not included in the consolidated balance sheet.

 

On March 12, 2003, theCompany completed an offering of $402.5 million of convertible subordinatednotes due March 1, 2008 to qualified buyers pursuant to Rule 144Aunder the Securities Act of 1933, as amended. The notes bear interest at a rateof 7/8% per annum and are convertible into the Company’s common stock at aconversion price of $23.79 per share and are subordinated to all present andfuture senior debt of the Company. Holders of the notes may convert their notesonly if: (i) the price of the Company’s common stock issuable uponconversion of a note reaches a specified threshold, (ii) specifiedcorporate transactions occur, or (iii) the trading price for the notesfalls below certain thresholds. At the initial conversion price, each $1,000principal amount of notes will be convertible into approximately 42.0345 sharesof common stock. Expenses associated with the convertible subordinated notesissuance were $11.7 million and have been recorded with in other long-termassets and are being amortized over the life of the notes.

 

Concurrent with the issuanceof the convertible notes, the Company entered into a convertible bond hedge andcall option transaction at a cost of $43.8 million. The convertible bondhedge allows the company to purchase 16.9 million shares of its commonstock at $23.79 per share from the other party to the agreement. The writtencall option allows the holder to purchase 16.9 million shares of theCompany’s common stock from the Company at $32.025 per share. Both the bondhedge and call option transactions may be settled at 

 

17

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the Company’s option eitherin cash or net shares and expire on March 1, 2008. The Company recordedthese instruments at cost, and their carrying value at March 31, 2005equaled their original cost*.* Theconvertible bond hedge and call option transactions are expected to reduce thepotential dilution from conversion of the notes. The options have been includedin stockholders’ equity in accordance with the guidance in Emerging Issues TaskForce Issue No. 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock.”

 

**15.                          WARRANTY OBLIGATIONSAND OTHER GUARANTEES:**

 

The Company provides a warrantyon its equipment and handset sales for a period generally ranging from one tothree years from the time of final acceptance. Very rarely, the Company hasentered into arrangements to provide limited warranty services for periodslonger than three years.  The longest ofsuch warranty periods is ten years. The Company provides for the expected costof product warranties at the time that revenue is recognized based on anassessment of past warranty experience.

 

Warranty obligations are asfollows (in thousands): 

 

| ** **                                        | ** ** | **Three months ended March 31,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                        | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                              |       |                                  |       |   |   |
| Beginning of period                               |       | $                                     | 46,596     |   | $ | 26,267 |   |
| Accruals for warranties issued during the  period |       | 23,089                                |       | 10,008 |   |
| Settlements made during the period                |       | (11,823                               | )          | (6,751 | ) |
| Balance at end of period                          |       | $                                     | 57,862     |   | $ | 29,524 |   |

 

*Warranty obligations:*

 

During the first quarter of2005, the Company incurred special warranty coverage for certain asynchronousdigital subscriber line (“ADSL”) equipment sold to Softbank BB Corporation (“SBBC”)during 2003 and 2004.  Since theagreement to repair these parts exceed the Company’s normal warranty terms, theCompany has recorded a special warranty charge in the current quarter of $9.5 million.Completion of the repair of these units is expected to be completed by the endof 2005.  For additional information,refer to Note 19, Related Party Transactions.

 

*Otherguarantees:*

 

Certain of the Company’ssales contracts include provisions under which customers would be indemnifiedby the Company in the event of, among other things, a third-party claim againstthe customer for intellectual property rights infringement related to theCompany’s products. There are no limitations on the maximum potential futurepayments under these guarantees. The Company has not accrued any amount inrelation to these provisions as no such claims have been made and the Companybelieves it has valid, enforceable rights to the intellectual property embeddedin its products.

 

**16.                          COMMITMENTS ANDCONTINGENCIES:**

 

*Leases:*

 

The Company leases certainfacilities under non-cancelable operating leases that expire at various datesthrough 2023.  The minimum future leasepayments under the leases at March 31, 2005 were as follows:

 

| **As of March 31, 2005** | ** ** | **(in thousands)** | ** ** |
|-------------------------------|------------|--------------------|------------|
| 1 year                        |       | $                  | 19,027     |   |
| 2 year                        |       | 11,639             |       |
| 3 year                        |       | 5,502              |       |
| 4 year                        |       | 2,680              |       |
| 5 year and after              |       | 4,502              |       |
| Total minimum lease payments  |       | $                  | 43,350     |   |

 

 

Rent expense for thequarters ended March 31, 2005 and 2004 were $5.6 million and $3.6 million,respectively.

 

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Other contractualobligations and commitments are as follows:

 

| ** **                             | ** ** | **March 31, 2005  Payments Due by Period** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|
| **(in thousands)**                     | ** ** | **Total**                                       | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** |
|                                   |       |                                            |       |   |   |   |   |   |   |
| Notes Payable                          |       | $                                               | 1,330      |   | $ | 1,330 |   | $ | — |   | $ | — |   |
| Bank Loans                             |       | $                                               | 274,155    |   | $ | 274,155 |   | $ | — |   | $ | — |   |
| Convertible Subordinated Notes         |       | $                                               | 402,500    |   | $ | — |   | $ | 402,500 |   | $ | — |   |
| Interest payable on Subordinated Notes |       | $                                               | 10,566     |   | $ | 1,761 |   | $ | 8,805 |   | $ | — |   |
| Standby letters of credit              |       | $                                               | 29,808     |   | $ | 27,226 |   | $ | 2,582 |   | $ | — |   |

 

*Notes payable*

 

Occasionally, the Companyissues short-term notes payable to its vendors in lieu of trade accountspayable.  The payment terms are normally three to nine months and aretypically non-interest bearing.

 

*Bank loans*

 

At March 31, 2005, theCompany had loans with various banks totaling $266.0 million with interestrates ranging from 3.04% to 4.35% per annum. These bank loans mature during 2005 and are included in short-term debt.

 

The Company has a bank loanin connection with an equipment purchase resulting from the consolidation ofMDC.  On January 10, 2003, a thirdparty established a bank loan with Shanghai Pudong Development Bank for thepurchase of the equipment.  Theobligations of the bank loan and related equipment were assumed by the Companyon January 23, 2003, and subsequently transferred to MDC on December 31,2003.  The bank loan of $8.2 millionbears interest at a rate of 4.94% per annum, and expires on January 10,2006.  The Company does not serve aslegal obligor for the loan.

 

*Convertible subordinated notes*

 

The Company has $402.5 millionof convertible subordinated notes, due March 1, 2008, that bear interestat a rate of 7/8% per annum, payable semiannually on May 1 and September 1,are convertible into the Company’s common stock at a conversion price of $23.79per share and are subordinated to all present and future senior debt of theCompany. The principal is due only at maturity of the notes.

 

*Standby letters of credit*

 

The Company issues standbyletters of credit primarily to support international sales activities outside ofChina. When the Company submits a bid for a sale, often the potential customerwill require that the Company issue a bid bond or a standby letter of credit todemonstrate its commitment through the bid process. In addition, the Companymay be required to issue standby letters of credit as guarantees for advancecustomer payments upon contract signing or performance guarantees. The standbyletters of credit usually expire six to twelve months from the date of issuancewithout being drawn by the beneficiary thereof. The Company may issuecommercial letters of credit in support of purchase commitments.

 

*Purchasecommitments*

 

The Company is obligated topurchase raw materials and work-in-process inventory under various orders from varioussuppliers, all of which should be fulfilled without adverse consequencesmaterial to the operations or financial condition of the Company. As of March 31,2005, total open commitments under these purchase orders were approximately$317.9 million.

 

*Investmentcommitments*

 

As of March 31, 2005,the Company had invested a total of $2.0 million in Global Asia PartnersL.P. The fund size is anticipated to be 

 

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$10.1 million and thefund was formed to make private equity investments in private or pre-IPOtechnology and telecommunications companies in Asia. The Company has acommitment to invest up to a maximum of $5.0 million. The remaining amountis due at such times and in such amounts as shall be specified in one or morefuture capital calls to be issued by the general partner.

 

*Intellectual property*

 

Certain sales contractsinclude provisions under which customers would be indemnified by us in theevent of, among other things, a third-party claim against the customer forintellectual property rights infringement related to our products. There are nolimitations on the maximum potential future payments under these guarantees.The Company has not accrued any amounts in relation to these provisions as nosuch claims have been made and the Company believes it has valid enforceablerights to the intellectual property embedded in its products.

 

*Litigation:*

 

*SecuritiesClass Action Litigation*

 

On October 26, 2004,an alleged former shareholder of the Company filed a class action complaint inthe United States District Court for the District of Idaho against the Companyand two of the Company’s directors and/or officers, purporting to assert claimsunder the federal securities laws on behalf of a class of purchasers of theCompany’s publicly traded securities in the period from April 16, 2003through September 20, 2004. Among other things, the complaint refers to the Company’s disclosures asto “significant control deficiencies” related to revenue recognition and as tothe deferral of revenue recognition on a particular transaction and the relatedlowering of the Company’s financial guidance. The complaint further alleges that the defendants previously madepositive statements regarding the Company’s business and financial performancethat were false and misleading because such statements, among other things,failed to disclose problems with the Company’s internal controls and revenuerecognition policies and procedures and failed to disclose that the revenue onthe transaction at issue would need to be deferred, which allegedly caused theprice of the Company’s publicly traded securities to be artificially inflated.The complaint claims that the plaintiff and other class members were damaged asa result thereof, and seeks monetary recovery in their favor in an unspecifiedamount.

 

Four similar class actioncomplaints were later filed in the United States District Court for theNorthern District of California against the Company and several of the Company’sdirectors and officers.  In both theIdaho court and the California court, competing motions were filed forappointment of lead plaintiff and approval of lead plaintiffs’ counsel, and inthe California court various motions for consolidation of actions were filed aswell.  On March 15 and 16, 2005, theCalifornia court entered orders consolidating the cases pending in that court,appointing the lead plaintiff and approving the lead plaintiff’s counsel.  Pursuant to those orders, a consolidatedcomplaint is to be filed in that court within 60 days thereafter.  On April 6, 2005, the Idaho courtentered an order appointing the lead plaintiff and approving the lead plaintiff’scounsel.  On April 18, 2005, theparties filed a stipulation to transfer the Idaho case to the California court,and on April 21, 2005, the Idaho court approved the stipulation andordered the transfer of the Idaho case to the California court forconsolidation with the actions pending in that court.

 

This class action litigationis in its preliminary stages, and the Company cannot predict its outcome, asthe litigation process is inherently uncertain. However, the Company believes that the allegations and claims in thislitigation are without merit and that it has valid defenses, and intends tocontest such allegations and claims and defend itself vigorously.  If the outcome of the litigation is adverseto the Company and if, in addition, the Company is required to pay significantmonetary damages, the Company’s business would be significantly harmed.  At a minimum, this litigation could result insubstantial costs and divert the Company’s management’s attention andresources, which could seriously harm the Company’s business.  As of March 31, 2005, no loss amount hasbeen accrued because a loss is not considered probable or estimable.

 

*ShareholderDerivative Litigation*

 

On August 31 and September 2, 2004,respectively, two shareholder derivative actions were filed in the SuperiorCourt of California, Alameda County, by alleged shareholders of the Companypurporting to assert, on the Company’s behalf, claims of breach of fiduciaryduty against certain of the Company’s current and former directors andofficers, and also naming the Company as a nominal defendant.  The complaints in these actions refer to theCompany’s disclosures as to an Audit Committee investigation into revenuerecognition issues and as to “significant control deficiencies” related torevenue recognition.  The complaintsfurther allege that the individual defendants ignored problems with the Company’saccounting and internal control practices and procedures and breached 

 

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their fiduciary duties byfailing to maintain adequate internal accounting controls or to make good faithefforts to do so.  Plaintiffs claim thatsuch alleged breaches damaged the Company, and they seek monetary recoveryagainst the individual defendants and in favor of the Company, as well asequitable relief.  In addition,plaintiffs claim that they should be excused from pre-suit demand requirementsbased on allegations that the Company’s Board of Directors could not havefairly evaluated such pre-suit demand, and thus that such demand would havebeen futile.  On November 22, 2004,the Court entered an order consolidating the two actions and appointing lead plaintiff’scounsel.

 

On November 23 and December 2, 2004,two related shareholder derivative actions were filed in the same court.  On January 13, 2005, the Courtconsolidated these two newer cases with the previously consolidated actions,and directed plaintiffs to prepare and file an amended consolidated complaint,which plaintiffs filed on January 31, 2005.  On March 17, 2005, the Company filed amotion, joined by other defendants, seeking dismissal of the consolidatedcomplaint for failure to adequately plead futility of the pre-suit demand.  On April 18, 2005, plaintiffs filedtheir opposition to that motion, and a hearing on the matter is currently setfor June 3, 2005.

 

This derivative litigationis in its preliminary stages, and the Company cannot predict its outcome, asthe litigation process is inherently uncertain. However, the Company believes that plaintiffs’ allegations of “demandfutility” are without merit, and the Company intends to contest thoseallegations vigorously.  At a minimum,this derivative litigation could result in substantial costs and divert theCompany’s management’s attention and resources, which could seriously harm theCompany’s business.  As of March 31,2005, no loss amount has been accrued because a loss is not considered probableor estimable.

 

*IPOAllocation*

 

On October 31, 2001,a complaint was filed in United States District Court for the Southern Districtof New York against the Company, some of the Company’s directors and officersand various underwriters for the Company’s initial public offering.  Substantially similar actions were filedconcerning the initial public offerings for more than 300 different issuers,and the cases were coordinated as In re Initial Public Offering Securities Litigation,21 MC 92.  In April 2002, aconsolidated amended complaint was filed in the matter against the Company,captioned In re UTStarcom, Initial Public Offering Securities Litigation, CivilAction No. 01-CV-9604. Plaintiffs allege violations of the Securities Act of 1933 and theSecurities Exchange Act of 1934 through undisclosed improper underwritingpractices concerning the allocation of IPO shares in exchange for excessivebrokerage commissions, agreements to purchase shares at higher prices in the aftermarketand misleading analyst reports. Plaintiffs seek unspecified damages on behalf of a purported class ofpurchasers of the Company’s common stock between March 2, 2000 and December 6, 2000.  The Company’s directors and officers havebeen dismissed without prejudice pursuant to a stipulation.  On February 19, 2003, the Courtgranted in part and denied in part a motion to dismiss brought by defendantsincluding the Company.  The orderdismisses all claims against the Company except for a claim brought under Section 11of the Securities Act of 1933, which alleges that the registration statementfiled in accordance with the IPO was misleading.  In June 2004, a stipulation ofsettlement and release of claims against the issuer defendants, including the Company,was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release allclaims against the participating defendants (including the Company).  In exchange for this dismissal, D&Oinsurance carriers would agree to guarantee a recovery by the plaintiffs fromthe underwriter defendants of at least $1 billion, and the issuerdefendants would agree to an assignment or surrender to the plaintiffs ofcertain claims the issuer defendants may have against the underwriters.  The settlement is subject to a number ofconditions, including court approval.  Ifthe settlement does not occur, and litigation against the Company continues,the Company believes it has valid defenses and intends to defend the casevigorously.  The total amount of the lossassociated with the above litigation is not determinable at this time.  Therefore, the Company is unable to currentlyestimate the loss, if any, associated with the litigation.

 

*StarentPatent Infringement Litigation*

 

The Company sued StarentNetworks Corporation (“Starent”) for patent infringement in the U.S. DistrictCourt for the Northern District of California. On March 22, 2004, the Company filed a Complaint.  On June 3, 2004, the Company servedthe Complaint on Starent.  On July 30, 2004,Starent filed and served its answer and counterclaims.  On August 30, 2004, the Companyserved and filed an Amended Complaint. In the Company’s Amended Complaint, the Company asserts that Starentinfringes a UTStarcom patent through the manufacture, use, offer for sale, andsale of Starent’s ST-16 Intelligent Mobile Gateway.  The Company seeks inter alia, compensatorydamages and injunctive relief.  Starentfiled its answer to the Amended Complaint and counterclaims on September 17, 2004. In its answer and counterclaims, Starentdenies the Company’s allegations and seeks a declaration that the patent-in-suitis not infringed, is invalid and is unenforceable.  The Court held an initial case managementconference on November 2, 2004 and scheduled a hearing to construethe claims of the patent-in-suit for June 30, 2005.  At that time the Court will hold anadditional case management conference to schedule a date for trial.  On February 17, 2005, the Company fileda motion for a 

 

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preliminary injunctionagainst Starent’s use, sale, and offer for sale of products having theinfringing feature.  A hearing on theCompany’s motion is set for May 11, 2005. The Company has indicated that it believes that any adverse judgment onStarent’s counterclaims will not have a material adverse effect on thebusiness, financial condition, or results of the Company’s operations. However,an evaluation of the possibility of a favorable or unfavorable outcome orestimate of the amount or range of potential loss to the Company has not been made.

 

On February 16, 2005, theCompany filed a second suit against Starent for patent infringement in the U.S.District Court for the Northern District of California.  On May 6, 2005, the Company served theComplaint on Starent.  In the Complaint,the Company assets that Starent infringes a UTStarcom patent through Starent’sdevelopment and testing of a software upgrade for its customer’s installedST-16 Intelligent Mobile Gateways.  The Companyseeks, inter alia, declaratory and injunctive relief.  The Court has set a case management conferencefor August 19, 2005.  This lawsuit is inits initial stages and Starent has not yet answered, counterclaimed, or otherwisefiled a response to the Company’s Complaint.

 

*FennerInvestments Patent Infringement Litigation*

 

On January 6, 2005,Fenner Investments, Ltd. filed suit against the Company and co-defendantsJuniper Networks, Inc., Nokia, Inc., Nortel Networks Corp., LucentTechnologies, Inc., and Cisco Systems, Inc. in the U.S. DistrictCourt for the Eastern District of Texas. The suit alleges that unspecifiedproducts and services infringe two Fenner patents and seeks compensatory andinjunctive relief. On March 1, 2005, the Company filed a motion to dismissthe complaint due to improper venue; no hearing is yet scheduled for thismotion. This lawsuit is in its initial stage and it is not possible to reliablypredict the outcome or any relief that could be awarded, as the litigationprocess is inherently uncertain. The Company intends to contest the allegationsand claims and defend itself vigorously. If the outcome of the litigation isadverse to the Company and if, in addition, the Company is enjoined or requiredto pay significant monetary damages, the Company’s business may be harmed. At aminimum, this litigation could result in substantial costs and divert theCompany’s management’s attention and resources, which could harm the Company’sbusiness.

 

*Other*

 

On August 19, 2004,the Company received a letter from the new management team of Hyundai Syscomm, Inc.(“HSI”) stating that they consider the Asset Purchase Agreement, dated as of February 26, 2004,among HSI, UTSI, Dr. Seong-Ik Jang and 3R Inc. (the ”APA”), and thevarious ancillary agreements entered into in connection with the closingrelated to the APA on April 27, 2004, to be null and void due tounfulfillment of condition precedents and material breach of terms of suchagreements.  Such condition precedentsand material breach of terms were not specified in such letter from HSI.  In addition, HSI has made allegations andarguments before Korean governmental agencies and to the Korean press allegingthat the technology that was purchased by the Company pursuant to the APA hasbeen exported outside of Korea.  TheCompany believes none of such technology has been exported by the Company fromKorea to any foreign country.  In addition,the Company believes that it has materially complied with all provisions of theAPA and the ancillary agreements and HSI cannot void or nullify suchagreements.  The Company has taken, andwill continue to take, appropriate legal actions to fully enforce its rightsunder the APA and the ancillary agreements. The Company believes that this dispute with HSI would not have amaterial adverse effect on the Company’s financial condition, results ofoperations or cash flow.

 

The Company is a party toother litigation matters and claims that are normal in the course ofoperations, and while the results of such litigation matters and claims cannotbe predicted with certainty, the Company believes that the final outcome ofsuch matters will not have a material adverse impact on its financial positionor results of operations.

 

**17.                          STOCKHOLDERS’ EQUITY:**

 

On January 14, 2004,the Company sold 12.1 million shares of common stock at $39.25 per sharein a privately negotiated transaction to an institution, for net proceeds ofapproximately $474.6 million. The net proceeds are intended to fundstrategic and general corporate activities, including, but not limited to,acquisitions, investments, working capital or capital expenditures.

 

On March 12, 2004, theCompany’s Board of Directors approved a stock repurchase program, authorizingthe Company’s repurchase of up to 5,000,000 shares of its outstanding commonstock over a period of 6 months. The Board approved an additional repurchase of1,623,000 shares in a privately negotiated transaction with an institution,which was completed in March 2004.  There were no shares repurchasedin the quarter ended March 31, 2005.

 

For the three months ended March 31,2005 and 2004, the Company had $0.7 million and $9.2 million,respectively, of net proceeds from the exercise of stock options.

 

**18.                          SEGMENT REPORTING:**

 

The Company historicallymanaged its business as a single reportable segment. During 2004, the Companycontinued to expand its focus on markets and operations outside of China.Effective with the fourth quarter of 2004, it was determined that the Company’s

 

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chief operating decisionmakers, in accordance with SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information,” were evaluating performance, makingoperating decisions and allocating resources based on two operating segments,i) China and ii) all other regions referred to as International (“International”).

 

On November 1,2004, the Company acquired selected assets of, the wireless handset division ofAudiovox Corporation. The acquired business has been integrated into theCompany as a separate and distinct operating division referred to as thePersonal Communications Division, (“PCD”). As the Company determined toevaluate performance and allocate resources to this division, it was considereda third operating segment.

 

As a result, as of December 31,2004, the Company was organized, principally based on geographical marketlocations, in three operating segments, China, International and PCD, and eachsegment consisted of one reporting unit.

 

Effective in the firstquarter of 2005, the Company elected to reorganize its business basedprincipally upon product lines and realigned its business into five operatingunits, namely Broadband Infrastructure, Wireless Infrastructure, Handsets, PCD,and Global Service Solutions.  Eachoperating unit represents its own reporting segment and each operating unit isresponsible for its own worldwide production and sales management.

 

The Company currentlyevaluates operating performance of and allocates resources to the reportingsegments based on segment gross profit. Cost of sales and direct expenses in relation to productions areassigned to the reporting segments. Corporate headquarter expenses and non-operating items are not allocatedto the segments.  The accounting policiesused in measuring segment assets and operating performance are the same as thoseused by corporate and are consistantly applied across all segments.

 

Summarized below are theCompany’s segment sales revenue and gross profit for the three months ended March 31,2005 and 2004, respectively, and long-lived assets and total assets as of March 31,2005 and December 31, 2004, respectively, based on the new reportingsegment structure.  For the three monthsended March 31, 2005, the Broadband segment included related party salesand gross profit of $283.0 million and $157.0 million,respectively.  In addition, for the threemonths ended March 31, 2005, the Service segment included related party revenueand gross profit of $12.6 million associated with promotionalservices.  See Note 19.  The prior period segment results have beenrevised to conform to the current presentation.

 
| ** **                       | ** ** | **Three  months ended March 31, 2005** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| ** **                       | ** ** | **Broadband**                               | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| **Sales by segment**             |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Revenue  from external customers |       | $                                           | 324,917    |   | $ | 109,951 |   | $ | 128,083 |   | $ | 315,552 |   | $ | 23,292 |   | $ | 901,795 |   |
| Gross  profit                    |       | 163,515                                     |       | 30,190 |   | 14,539 |   | 13,692 |   | 16,253 |   | 238,189 |   |
|                             |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| ** **                       | ** ** | **Three  months ended March 31, 2004** | ** ** |
| ** **                       | ** ** | **Broadband**                               | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| **Sales by segment**             |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Revenue  from external customers |       | $                                           | 36,700     |   | $ | 336,517 |   | $ | 236,442 |   | — |   | $ | 12,633 |   | $ | 622,292 |   |
| Gross  profit                    |       | 16,889                                      |       | 152,236 |   | 2,562 |   | — |   | 4,347 |   | 176,034 |   |
|                             |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| ** **                       | ** ** | **As  of March 31, 2005**              | ** ** |
| ** **                       | ** ** | **Broadband**                               | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total  long-lived assets         |       | $                                           | 56,723     |   | $ | 96,882 |   | $ | 54,423 |   | $ | 1,183 |   | $ | 69,276 |   | $ | 278,487 |   |
| Total  assets                    |       | 831,845                                     |       | 961,365 |   | 716,828 |   | 467,643 |   | 89,371 |   | 3,067,052 |   |
|                             |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| ** **                       | ** ** | **As  of December  31, 2004**          | ** ** |
| ** **                       | ** ** | **Broadband**                               | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total  long-lived assets         |       | $                                           | 50,454     |   | $ | 106,003 |   | $ | 46,325 |   | $ | 1,330 |   | $ | 64,647 |   | $ | 268,759 |   |
| Total  assets                    |       | 1,018,608                                   |       | 1,184,649 |   | 676,022 |   | 363,298 |   | 73,428 |   | 3,316,005 |   |

 

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Geographical area sales dataare as follows (in thousands):

 

| ** **          | ** ** | **Three months ended March 31,** | ** ** |
|---------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Sales by region** |       |                                  |       |   |   |   |   |   |   |
| Japan               |       | $                                     | 329,708    |   | 37% |   | $ | 19,427 |   | 3% |   |
| United States       |       | 302,176                               |       | 33% |   | 17,372 |   | 3% |   |
| China               |       | 227,209                               |       | 25% |   | 570,566 |   | 92% |   |
| Other               |       | 42,702                                |       | 5% |   | 14,927 |   | 2% |   |
| **TOTAL NET SALES** |       | $                                     | 901,795    |   | 100% |   | $ | 622,292 |   | 100% |   |

 

Long-lived assets bygeographical areas are as follows (in thousands):

 

| ** **                  | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| U.S.                        |       | $                        | 22,968     |                        | $          | 24,958 |   |
| China                       |       | 242,996                  |       | 229,469                     |       |
| Other                       |       | 12,523                   |       | 14,332                      |       |
| **Total long-lived assets** |       | $                        | 278,487    |                        | $          | 268,759 |   |

 

**19.                          RELATED PARTYTRANSACTIONS:**

 

*Softbank*

 

The Company recognizedrevenue of $24.3 million and $11.6 million during the quarters ended March 31,2005 and 2004, respectively, with respect to sales of telecommunicationsequipment to SBBC, an affiliate of SOFTBANK CORP. and SOFTBANKAmerica Inc., which, as of March 31, 2005, owned 12.8% of the Company’soutstanding stock. SBBC offers asynchronous digital subscriber line (“ADSL”)coverage throughout Japan, which is marketed under the name “YAHOO! BB.” Inaddition, the Company supports SBBC’s new fiber-to-the-home service throughsales of its carrier class Gigabit Ethernet Passive Optical Network (“GEPON”)product as well as its multi-service optical transport product (“NetRingTM”).

 

Included in accountsreceivable at March 31, 2005 and December 31, 2004 were $94.2 millionand $86.8 million, respectively, related to these agreements. Customeradvances were $5.5 million as of both March 31, 2005 and December 31,2004.  Deferred revenue was $6.2 millionand $0.5 million as of March 31, 2005 and December 31, 2004,respectively.

 

During August 2004, theCompany entered several agreements with Japan Telecom Co., Ltd (“JT”), a whollyowned subsidiary of SOFTBANK Corp., related to the sale of telecommunicationequipment and promotional services. The nature of these agreements contemplatethe sale of *i*AN-8000equipment with specified value and delivery dates, as well as an oral agreementwhich subsequently converted into specific service contracts to manage a salespromotional program for JT. The total gross value of this agreement is $534.1 million.The Company has determined that the service activities revenue should berecorded net of expected promotional spending.

 

Because the Company had notprovided these activities in the past and could not estimate the fair value ofthese services, the Company determined under the guidance of SAB 104 that allrevenue related to these agreements would be deferred and included in customeradvances, until the above-mentioned promotional obligations were complete. Asof March 31, 2005, the Company had delivered and received final acceptancefor all equipment contemplated under these agreements.  In addition, $72.4 million was 

 

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included in accountsreceivable at March 31, 2005 and $217.5 million included in customeradvance as of December 31, 2004, related to these agreements.  Deferred revenue at March 31, 2005 was $11.1 million.

 

The promotional servicesdiscussed above involved contracting with third party promotional vendors, whoin turn facilitated the marketing and subscriber recruitment for the JTfiber-to-the-home program. During the fourth quarter of 2004, the Companydetermined that it would end its involvement with the JT promotional programafter completion of the contract discussed above. Accordingly, late in thefourth quarter of 2004 and during the first quarter of 2005, the Company eithercancelled or assigned to another party, all third party contracts withpromotional vendors related to the JT contract. Such termination or assignmentof all third party promotional agreements, as well as effective satisfaction ofobligations with JT under such agreements has satisfied the revenue recognitioncriteria for these agreements and as such, the net value of the promotionalservices and the value of equipment delivered, which totaled $204.8 million,has been reported in the quarter ended March 31, 2005.

 

The Company also entered intoan agreement with JT during the third quarter of 2004 to supply chassisequipment with an approximate value of $75.3 million. As of March 31 2005,$72.3 million shipped under this agreement and is considered linked to the *i*AN-8000 sale noted above and assuch, was also deferred until the completion of the above-mentioned promotionalactivities.  As discussed above, therevenue recognition criteria related to the sale of the *i*AN-8000 equipment was satisfied inthe first quarter of 2005 and as such, the revenue related to the chassis saleof $66.5 million has been reported in the quarter ended March 31,2005.  Deferred revenue at March 31,2005 was $5.8 million related to this agreement.

 

The Company has invested inSoftbank China and Restructuring Fund No. 1, which are investment vehiclesestablished by SOFTBANK CORP. and its affiliates.  See Note 13.

 

On July 17, 2003, theCompany entered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BBModem”), an affiliate of SOFTBANK CORP. Under the terms of the agreement, theCompany loaned BB Modem $10.1 million at an effective interest rate of12.01% per annum, for the purpose of investing in a portfolio of ADSL modemsand associated modem rental agreements, from SBBC. SBBC will continue toservice such modems and modem rental agreements. The Company’s loan issubordinated to certain senior lenders of BB Modem, and repayments are payableto the Company over a 42-month period through January 31, 2007, witha substantial portion of the principal amount of the loan scheduled to berepaid during the last 16 months of this period. The Company’s recourse fornonpayment of the loan is limited to the assets of BB Modem, the account intowhich subscriber payments are made and its rights under the securitizationtransaction documents. The value of BB Modem’s modems that serve as collateralfor the loan may decrease over time and may not be sufficient upon sale to paythe outstanding amounts on the loans. The Company assesses the loan forimpairment whenever events or changes in circumstances indicate that thecarrying amount may not be recoverable. The Company periodically reviews theunderlying quality of the asset pool securing the loan to assess whetherimpairment has incurred and needs to be recorded. During the three months endedMarch 31, 2005 and 2004, the Company recorded $0.3 million and $0.3 million,respectively, in interest income in respect to this loan. The loans receivableat March 31, 2005 and December 31, 2004 were approximately $11.3 millionand $11.8 million, respectively and were included in other long-termassets.

 

On April 5, 2003, theCompany repurchased 8.0 million shares of common stock beneficially ownedby SOFTBANK America Inc., at a purchase price of $17.385 per share. The totalcost of the repurchase was $139.6 million including transaction fees. Inconnection with this repurchase transaction, SOFTBANK America Inc.entered into an agreement with the Company not to offer, sell or otherwisedispose of the Company’s common stock for a period of one year, subject to anumber of exceptions. As of March 31, 2005, SOFTBANK America Inc.beneficially owned approximately 12.8% of the Company’s outstanding stock.

 

On August 29, 2002, theCompany completed the repurchase of 6.0 million shares of the company’scommon stock for $72.9 million from SOFTBANK America, Inc.

 

*CellonInternational*

 

In October 2002, theCompany entered into a license and a royalty agreement with CellonInternational Holding Corporation (“Cellon”), in which the Company has a 9%ownership interest. Per the terms of the royalty agreement, the Company isrequired to pay Cellon $3.00 per unit shipped for a minimum of 0.1 millionunits. This agreement is not material to the overall financial results ofCellon. The Company has evaluated its relationship with Cellon under FIN 46,and determined that consolidation is not necessary.

 

*Fiberxon*

 

The Company has anoutstanding purchase commitment with Fiberxon, in which the Company has an 11%ownership interest, to 

 

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purchase component parts foroptical networking products. The Company anticipates it will be able to fulfillthis commitment without adverse consequences material to the operations orfinancial condition of the Company. Purchases from Fiberxon totaled $5.0 millionduring the 3 months ended March 31, 2005. As of March 31, 2005 theCompany had $2.7 million in open purchase commitments and $1.9 millionin accounts payable to Fiberxon.

 

*StarcomProducts, Inc.*

 

The Company obtainsengineering consulting and employee placement services from Starcom Products, Inc.(“Starcom”), which is 31% owned by an individual related to a member of theCompany’s Board of Directors. The Company paid $1.1 million to Starcom in2004.   The Company obtained no services fromthis entity in the three months ended March 31, 2005.

 

**20.****                                                                               OTHERINCOME AND EXPENSES:**

 

Net other income or expensewas an expense of $6.8 million and an income of $8.8 million for thethree months ended March 31, 2005 and 2004, respectively.  The balances were comprised of the following:

 

| ** **                           | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **(in millions)**                | ** ** |
| **Other Income /(Expense)**          | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Japan consumption tax refund         |       | 1.2                                   |       | 1.4 |   |
| Foreign exchange gains (losses)      |       | (7.8                                  | )          | (0.4 | ) |
| Chinese government financial subsidy |       | 0.5                                   |       | 7.8 |   |
| Other                                |       | (0.7                                  | )          | — |   |
| **Total**                            | ** ** | **$**                                 | **(6.8**   | **)** | **$** | **8.8** | ** ** |
|                                      |            |                                       |            |  |  |  |  |

 

**21.                          CREDIT RISK AND CONCENTRATION**

 

Historically, a substantialmajority of the Company’s sales have been to telecommunications serviceproviders in China. Accordingly, the Company’s business, financial conditionand results of operations are likely to be influenced by the political,economic and legal environment in China and by the general state of China’seconomy. The Company’s results may be adversely affected by, among otherthings, changes in the political, economic, competitive and social conditionsin China, including changes in governmental policies with respect to laws andregulations, changes in China’s telecommunications industry and regulatory rules andpolicies, anti-inflationary measures, controls over currency conversion andremittance abroad, and rates and methods of taxation.

 

Under China’s currentregulatory structure, the communications products that the Company offers inChina must meet government and industry standards, and a network access licensefor the equipment must be obtained. Without the license, the equipment may notbe connected to public telecommunications networks or sold in China. Moreover,the Company must ensure that the quality of the telecommunications equipmentfor which it has obtained a network access license is stable and reliable, andmay not lower the quality or performance of other installed licensed products.China’s State Council’s product quality supervision department, in concert withChina’s Ministry of Information Industry, performs spot checks to track andsupervise the quality of licensed telecommunications equipment and publishesthe results of such spot checks.

 

In fiscal 2004, the Companycontinued to focus on the diversification of its global customer base and internationalmarket penetration; and as a result, the Company’s sales derived from China asa percentage of total sales have declined.

 

For the three months ended March 31,2005, and 2004, 25% and 92% of the Company’s sales, respectively, were derivedfrom China.  For the three months ended March 31,2005, sales recorded in Japan accounted for 37% of total sales, mainlyresulting from the recognition of deferred revenue recorded in priorquarters.  Refer to Note 19, RelatedParty Transactions for additional information.

 

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The table below outlines theCompany’s sales to, and the accounts receivable balances from its largestcustomers:

 

**For the threemonths ended March 31,**

 

| ** ** | ** ** | **% of Net  Sales** | ** ** | **% of  Accounts  Receivable** | ** ** |
|------------|------------|---------------------|------------|--------------------------------|------------|
| **2005**   | ** ** | ** **          | ** ** | ** **                     | ** ** |
| **C**      |       | 33%                 |       | 18%                            |       |
| **D**      |       | 14%                 |       | 3%                             |       |
|       |       |                |       |                           |       |
| **2004**   | ** ** | ** **          | ** ** | ** **                     | ** ** |
| **A**      |       | 24%                 |       | 8%                             |       |
| **B**      |       | 13%                 |       | 2%                             |       |

 

**22.****                                                                              ****INCOME TAX ASSETS ANDLIABILITIES:**

 

In establishing its deferredincome tax assets and liabilities, the Company makes judgments andinterpretations based on the enacted tax laws and published tax guidanceapplicable to its operations as well as the amount and jurisdiction of futuretaxable income.  The Company records deferred tax assets and liabilitiesand evaluates the need for valuation allowances to reduce the deferred taxassets to realizable amounts.  The likelihood of a material change in theCompany’s expected realization of these assets is dependent on future taxableincome, its ability to use foreign tax credit carryforwards and carrybacks, andthe effectiveness of its tax planning strategies in the various relevantjurisdictions.  Changes to the Company’s income tax provision or in thevaluation of the deferred tax assets and liabilities may affect its annualeffective income tax rate.

 

Income tax expense was $7.9million and $13.7 million for the three months ended March 31, 2005 and2004, respectively.   The Company’s 2005annual effective tax rate is estimated to be 27%, except discrete items.  In the quarter ended March 31, 2005, theCompany also recorded a $4.7 million reduction in tax expense attributable toan increase in deferred tax assets arising from the assessment of a localincome tax for two entities in China. The difference between the U.S. statutory rate of 35% and the 2005estimated rate of 27% is attributable to expected utilization of operatinglosses, permanent tax deductions related to the Company’s convertible debtoffering in 2003 and lower tax rates in various jurisdictions the Company operatesin, partially offset by application of state income taxes.

 

**23.****                                                                              ****ACCOUNTING FOR DERIVATIVEINSTRUMENTS AND HEDGING ACTIVITIES:**

 

The Company uses derivativefinancial instruments to manage its exposures to foreign currency exchange ratechanges. The derivative instruments are accounted for pursuant to SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities,” as amended bySFAS No. 138, “Accounting for Certain Derivative Instruments and CertainHedging Activities” (“SFAS 133”). As amended, SFAS 133 requires that an entityrecognize all derivatives as either assets or liabilities on the balance sheet,measure those instruments at fair value and recognize changes in the fair valueof derivatives in earnings in the period of change unless the derivativequalifies as an effective hedge that offsets certain exposures. Such contractsare designated at inception to the related foreign currency exposures beinghedged. Beginning in the first quarter of 2004, the Company hedged certain ofits Japanese Yen-denominated balance sheet exposures against future movementsin foreign currency exchange rates by using foreign currency forward contracts.Hedged transactions are denominated in U.S. dollars on behalf of thesetransactions denominated in Japanese Yen. Pursuant to its foreign currency exchangehedging policy, the Company may hedge anticipated transactions and the relatedpayables denominated in foreign currencies using forward foreign currencyexchange rate contracts.  Gains and losses on these fair value hedges areintended to offset gains and losses from the revaluation of JapaneseYen-denominated recognized liabilities. There were no hedging activities in thethree months ended March 31, 2005. The net result of these gains andlosses on contracts and revaluation included in interest and other income(expense) was insignificant for the three months ended March 31, 2004. TheCompany’s foreign currency forward contracts generally mature within threemonths. These derivative financial instruments are not held for speculativetrading purposes. There were no foreign currency forward contracts open at March 31,2005.

 

**24.****                                                                              ****RECENT ACCOUNTINGPRONOUNCEMENTS:**

 

 In December 2004, the Financial Accounting Standards Board, “FASB”issued SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”).  SFAS 123(R) will require the Company tomeasure all employee stock-based compensation awards using a fair value

 

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methodand record such expense in its consolidated financial statements.  In addition, the adoption of SFAS 123(R) willrequire additional accounting related to the income tax effects and additionaldisclosure regarding the cash flow effects resulting from share-based paymentarrangements.

 

InMarch 2005, the Securities and Exchange Commission (the “SEC”) issuedStaff Accounting Bulletin no. 107 (“SAB 107”) which provides guidance regardingthe application of SFAS 123(R). SAB 107 expresses views of the staff regardingthe interaction between SFAS No. 123(R), Share-Based Payment, and certainSEC  rules and regulations andprovides the staff’s views regarding the valuation of share-based paymentarrangements for public companies. In particular, SAB 107 provides guidancerelated to share-based payment transactions with non-employees, the transitionfrom nonpublic to public entity status, valuation methods (includingassumptions such as expected volatility and expected term), the accounting forcertain redeemable financial instruments issued under share-based paymentarrangements, the classification of compensation expense, non-GAAP financialmeasures, first-time adoption of SFAS 123(R) in an interim period,capitalization of compensation cost related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentarrangements upon adoption of SFAS 123(R), the modification of employee shareoptions prior to adoption of SFAS 123(R) and disclosures in Management’sDiscussion and Analysis (“MD&A”) subsequent to adoption of SFAS 123(R).

 

On April 14, 2005, theSEC approved a new rule that delays the effective date for SFAS 123(R) toannual periods beginning after June 15, 2005.  The adoption of SFAS 123(R) on January 1,2006 is expected to have a material impact on the Company’s consolidatedresults of operations, financial position and statement of cash flows.  The Company is evaluating the transitionmethod and pricing model alternatives upon adoption.

 

In December 2004, the FASBissued FSP No. FAS 109-2, “Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provision within the American Jobs Creation Act of2004.”  The American Jobs Creation Act of2004 provides a one-time 85% dividends received deduction for certain foreignearnings that are repatriated under a plan for reinvestment in the UnitedStates, provided certain criteria are met. FSP No. FAS 109-2 is effective immediately and provides accounting anddisclosure guidance for the repatriation provision.  FSP No. FAS 109-2 allows companies additionaltime to evaluate the effects of the law on its unremitted earnings for thepurpose of applying the “indefinite reversal criteria” under APB Opinion No.23, “Accounting for Income Taxes—Special Areas,” and requires explanatorydisclosures from companies that have not yet completed the evaluation.  The Company is currently evaluating theeffects of the repatriation provision and their impact on its consolidatedfinancial statements.  The Company doesnot expect to complete this evaluation before the end of 2006.  The range of possible amounts of unremittedearnings that is being considered for repatriation under this provision isbetween zero and $540 million and the related potential range of income tax isbetween zero and $28 million.

 

**25.****                                                                              ****SUBSEQUENT EVENTS:**

 

*Filing of Annual Report on Form 10-K*

 

On March 31, 2005, theCompany filed a current report on Form 8-K with the SEC disclosingthat the Company would delay the filing of its Annual Report on Form 10-Kfor the year ended December 31, 2004. The delay resulted in a technical default of the Company’s 7/8%Convertible Subordinated Notes due 2008. The default would have become an event of default pursuant to the terms ofthe indenture for the notes if the Company had failed to file its 2004 Form 10-Kwithin 60 days of written notice of the default being provided to the Companyby either the trustee under the indenture or the holders of at least 25% inaggregate principal amount of the notes then outstanding.  On April 5, 2005, the Company received a NasdaqStaff Notice relating to its failure to file its Annual Report on Form 10-K withthe SEC by March 31, 2005.  The Companyfiled its Annual Report on Form 10-K on April 15, 2005, and,therefore, no event of default occurred with regards to the notes.  In addition, theCompany received notice from Nasdaq, on April 21, 2005, that it hasevidenced compliance with the filing requirement and all other requirements forcontinued listing on The Nasdaq National Market.

 

*Restructuring plan*

 

On May 5, 2005, theCompany announced a restructuring plan to optimize its cost structure and bemore operationally cost efficient.  Inlight of the downturn in its China business and to realign the business tobetter meet the demands of market conditions, the Company plans to reduce itswork force and to expand outsourcing of supply-chain and information technologyoperations in an effort to reduce its cost structure.  The Company expects to implement the plans inthe second quarter of 2005 and as such will likely recognize a nonrecurringcharge of approximately $20-$25 million associated with theserestructuring plans in the quarter ended June 30, 2005.

 

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**ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**FORWARD-LOOKINGSTATEMENTS**

 

This Report on Form 10-Qcontains forward-looking statements within the meaning of the federalsecurities laws.  These statements arebased on information that is currently available to management.  We intend such forward-looking statements tobe covered by the safe harbor provisions of the Private Securities LitigationReform Act of 1995, and we are including this statement for purposes ofcomplying with those provisions.  Theforward-looking statements include, without limitation, those concerning thefollowing: our expectations as to the nature of possible trends, including ourexpectations about continuing growth in the number of subscribers fortelecommunications products in the countries in which we do business; ourexpectations regarding continued growth in our business and operations; ourexpectations regarding competition in the markets in which we compete; ourexpectation that there will be fluctuations in our overall gross profit, grossmargin, product mix, quarter to quarter results, customer base and sellingprices; our expectations regarding our annual effective tax rate; our plans forexpanding the direct sales organization and our selling and marketing campaignsand activities; our expectation that we may use our cash, debt or securities toacquire or invest in complementary businesses, technologies or productofferings; our expectations regarding trends in customer acceptance of ourproducts; our expectation that there will be increases in selling, marketing,research and development, and general and administrative expenses; ourexpectations regarding future growth of our business and operations; ourexpectations regarding our ability to take advantage of strategic investmentopportunities; our expectations regarding the status of products underdevelopment; our expectations regarding our future levels of cash and cashequivalents, as well as our expectation that existing credit facilities,short-term investments, lines of credit, cash and cash equivalents will be availableand sufficient to finance our operations for the foreseeable future; ourexpectations regarding the potential impact on our results of operations,financial position and statement of cash flows from changes in legal andaccounting regulations, such as SFAS 123(R), our expectations regardinglicensing requirements and our ability to receive licenses in China for our PASsystem and other products; our expectations regarding the development of 3Gnetworks in China; our expectations regarding the impact of a reorganization oftelecommunications companies in China; our expectation that our business will continue to be significantlyinfluenced by the political, economic and legal environment in China, as wellas expectations about the nature of political, economic and legal reform inChina; our expectations regarding the importance of sales in China to ouroperating results; our expectations regarding the future allocation of netsales by product group and geographic location; our expectations regardingefficiencies we hope to achieve in supply chain management and inventorypurchasing, as well as trends in inventory growth; our expectations regardingthe evolution of our internal controls over financial reporting; ourexpectations regarding our ability to implement and enhance our administrativeinfrastructure; our expectations regarding our ability to optimize our coststructure and become more operationally cost effective resulting from a restructuringplan and our expectations regarding our expansion into new markets around theworld and the transformation of our operations to address potential marketopportunities.  Additionalforward-looking statements may be identified by the words “anticipate,”“expect,” “believe,” “intend,” “will,” and similar expressions, as they relateto us or our management.  Investors arecautioned that these forward-looking statements are inherently uncertain.  These statements are subject to risks anduncertainties that may cause actual results and events to differmaterially.  For a detailed discussion ofthese risks and uncertainties, see the “Factors Affecting Future OperatingResults” section of this Form 10-Q.  We do not guarantee future results andundertake no obligation to update the forward-looking statements to reflectevents or circumstances occurring after the date of this Form 10-Q.

 

**EXECUTIVESUMMARY**

 

We design, manufacture andsell telecommunications equipment and handset products and provide servicesassociated with their operation. Our telecommunication equipment products aredeployed and installed globally primarily by wireless and wirelinetelecommunications service providers. We provide an extensive range of productsfor transportation of voice, data and video traffic for these serviceproviders. We are currently operating in China, Japan, India, the Central andLatin American region, North America, the European, Middle Eastern and Africanregion and southeastern and northern Asia.

 

We differentiate ourselveswith products designed to reduce network complexity, integrate high performancecapabilities and allow a simple transition to next generation networks. Wedesign our products to facilitate cost-effective and efficient deployment,maintenance and upgrades.

 

Ourkey product families fall into three major categories:

 

•                  WirelessInfrastructure:   technologies and products that enable end users, orsubscribers, to send and receive voice and data communication in either a fixedor mobile environment by using wireless devices;

 

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•                  BroadbandInfrastructure:   technologies and products that enable end users to accesshigh-speed, cost effective fixed data and voice and media communication; and

 

•                  Handsets andCustomer Premise Equipment (“CPE”):   consumer devices that allow customersto access wireless and broadband services.

 

Weoperate our business in five segments (i) Broadband Infrastructure, (ii) WirelessInfrastructure, (iii) Handsets, (iv) Personal CommunicationsDivision, (“PCD”), and (v) Services. Based principally upon the aforementionedproduct categories, for the three months ended March 31, 2005, we recorded$901.8 million of revenue, a 45% increase over $622.3 million from thecorresponding period in 2004. Historically, a substantial majority of our sales have been to serviceproviders in China.  In fiscal 2004, we continued to focus on thediversification of our global customer base and market penetration internationally,and, as a result, our sales derived from outside of China as a percentage oftotal sales have increased.  For thethree months ended March 31, 2005, 25% of our sales were derived fromChina as compared to 92% for the three months ended March 31, 2004.  This shift in market concentration andrevenue is due to the combination of China’s continued slow-down in its economysince the fourth quarter of 2004 and our ability to capture growthopportunities internationally as well as the incremental sales contributed byPCD subsequent to its acquisition in November 2004.   In addition, we posted stronger salesrevenue in Japan principally resulting from the recognition of revenuepreviously deferred in relation to certain agreements with Japan Telecom.

 

China has been our largestmarket and we believe that it will continue to be an important market for ourcurrent and future technologies and development for the foreseeablefuture.  However, we have alsoexperienced a maturation of our PAS market in China resulting in our need to havea more diversified product and customer base. We also believe sales generated from China, as a percentage of totalsales, may continue to decline as we continue to grow internationally.

 

We use subscriber growthstatistics to gauge future inventory purchasing requirements as well as toforecast our anticipated revenue growth. We expect this subscriber growth tocontinue throughout 2005 since China’s teledensity rates, or the number oftelephones per person in a region, remain low in comparison to that ofdeveloped countries.

 

*The number of competitors for communications access andswitching systems and handsets in China has grown in line with China’stelecommunications market expansion. This growth has led to competitive pricingpressure, causing average selling prices to decrease during the three monthsended March 31, 2005 relative to those in the comparative period in2004. This pricing pressure affected both our wireless infrastructure andhandset product lines, contributing to lower gross profit overall.  In addition, our overall gross profit islower, in part, because the gross profit on handset sales by PCD, whichaccounts for approximately one third of our total sales in the current quarter,are significantly lower than gross profit related to our Personal Access System(“PAS”) based handsets.*

* *

We strive to developproducts with more advanced features and to enhance the features of ourexisting products, which we believe will enable us to offer our customers moreadvanced products at higher average selling prices than otherwise would bepossible in the future.

 

Over the past few years, wehave undertaken a significant globalization program and we intend to continueto expand our global sales outside of China in the current year. As we expand,we will continue to improve our internal supply chain and inventory managementprocesses to ensure timely deliveries. We will also continue to implement andenhance our administrative infrastructure to assist with our growth andglobalization transformation.

 

KEY TRANSACTIONS

 

*Acquisition*

 

On October 29, 2004, weentered into an asset purchase agreement with Giga Telecom, Inc.,(“Giga”), a Korean corporation that develops and designs wireless handsets. Theacquisition is to facilitate our expansion into the Code Division MultipleAccess (“CDMA”) handset market.  With theacquisition, we gained instant access to an experienced design team ofapproximately 100 employees.

 

The acquisition wascompleted on January 4, 2005. At the closing, $13.0 million in cash waspaid, and an additional $2.0 million was paid into an escrow account held by usfor six months.  The total considerationfor the acquisition, funded from cash on hand, was approximately $18.5 million,including $2.0 million acquisition-related transaction costs and $1.5 millionpayment previously made to be applied against the purchase price.  An earn-out of up to $2.0 million may becomepayable upon completion of certain product design milestones which will beadjusted to be part of the purchase price in accordance with Statement ofFinancial Accounting Standards No. 141, “Business Combinations.”  As of March 31, 2005, no milestones havebeen met and no contingent payment was accrued.

 

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The purchased existing technologyand pre-existing royalty agreement are to be amortized within a year.  The results of operation of Giga have beenintegrated with the “Handsets” segment subsequent to the acquisition.

 

*Subsequentevents:*

 

Filingof Annual Report on Form 10-K

 

On March 31, 2005, wefiled a current report on Form 8-K with the SEC disclosing that wewould delay the filing of our Annual Report on Form 10-K for theyear ended December 31, 2004.  Thedelay resulted in a technical default of our 7/8% Convertible Subordinated Notes due 2008.  The default would have become an event ofdefault pursuant to the terms of the indenture for the notes if we had failedto file our 2004 Form 10-K within 60 days of written notice of thedefault being provided to us by either the trustee under the indenture or theholders of at least 25% in aggregate principal amount of the notes thenoutstanding.  In addition, on April 5,2005, we received a Nasdaq Staff Notice relating to our failure to file ourAnnual Report on Form 10-K with the SEC by March 31 2005.  We filed our Annual Report on Form 10-Kfor the year ended December 31, 2004 on April 15, 2005 and, therefore,no event of default occurred with regards to our notes.  In addition, wereceived notice from Nasdaq, on April 21, 2005, that we have evidencedcompliance with the filing requirement and all other requirements for continuedlisting on The Nasdaq National Market.

 

Restructuring plan

 

On May 5, 2005, weannounced a restructuring plan to optimize our cost structure and be moreoperationally cost efficient.  In lightof the downturn in our China business and to realign us to better meet thedemands of market conditions, we plan to reduce our work force and to expandoutsourcing of supply-chain and information technology operations in an effortto reduce our cost structure.

 

We expect to implement theplans in the second quarter of 2005 and as such will likely recognize anonrecurring charge of approximately $20-$25 million associated withthese restructuring plans in the quarter ended June 30, 2005.

 

**RELATEDPARTY TRANSACTIONS:**

 

*Softbank*

 

We recognized revenue of$24.3 million and $11.6 million during the quarters ended March 31, 2005and 2004, respectively, with respect to sales of telecommunications equipmentto SBBC, an affiliate of SOFTBANK CORP. and SOFTBANK America Inc., whichis one of our significant stockholders. SBBC offers asynchronous digitalsubscriber line (“ADSL”) coverage throughout Japan, which is marketed under thename “YAHOO! BB.” In addition, we support SBBC’s new fiber-to-the-home servicethrough sales of its carrier class Gigabit Ethernet Passive Optical Network(“GEPON”) product as well as its multi-service optical transport product(“NetRingTM”).

 

During the first quarter of2005, we agreed to incur special warranty coverage for certain ADSL equipmentsold to SBBC during 2003 and 2004.  Becauseour agreement to repair these parts exceeds our normal warranty terms, we haverecorded a special warranty charge in the first quarter 2005 totaling of $9.5million. Completion of the repair of these units is expected to be completed bythe end of 2005.

 

Included in accountsreceivable at March 31, 2005 and December 31, 2004 were $94.2 millionand $86.8 million, respectively, related to these agreements. Customeradvances were $5.5 million as of both March 31, 2005 and December 31,2004.  Deferred revenue was $6.2 millionand $0.5 million as of March 31, 2005 and December 31, 2004,respectively.

 

During August 2004, weentered into several agreements with Japan Telecom Co., Ltd (“JT”), a whollyowned subsidiary of SOFTBANK Corp., related to the sale of telecommunicationequipment and promotional services. The nature of these agreements contemplatethe sale of *i*AN-8000equipment with specified value and delivery dates, as well as an oral agreementwhich subsequently converted into specific service contracts to manage a salespromotional program for JT. The total gross value of this agreement is $534.1million. We have determined that the service activities revenue should berecorded net of expected promotional spending.

 

Because we have not providedthese activities in the past and cannot estimate the fair value of theseservices, we determined under the guidance of SAB 104 that all revenue relatedto these agreements would be deferred and included in customer advances, untilthe above-mentioned promotional obligations were complete. As of March 31,2005, we have delivered and received final acceptance for all equipmentcontemplated under these agreements.  Inaddition, $72.4 million was included in accounts receivable at March 31,2005

 

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and $217.5 million includedin customer advances as of December 31, 2004 relating to theseagreements.  Deferred revenue was $11.1million at March 31, 2005.

 

The promotional servicesdiscussed above involved contracting with third party promotional vendors who,in turn, facilitated the marketing and subscriber recruitment for the JTfiber-to-the-home program. During the fourth quarter of 2004, we determinedthat we would end our involvement with the JT promotional program aftercompletion of the contract discussed above. Accordingly, late in the fourthquarter of 2004 and during the first quarter of 2005, we either cancelled orassigned to another party, all third party contracts with promotional vendorsrelated to the JT contract. Such termination or assignment of all third partypromotional agreements, as well as effective satisfaction of obligations withJT under such agreements has satisfied the revenue recognition criteria forthese agreements and as such, the net value of the promotional services and thevalue of equipment delivered, which totaled $204.8 million, has been reportedin the quarter ended March 31, 2005.

 

We also entered into anagreement during the third quarter of 2004 to supply chassis equipment with anapproximate value of $75.3 million. As of March 31, 2005, $72.3 million shippedunder this agreement and is considered linked to the Multi-Service Access Node(“iAN-8000”) sale noted above and as such, revenue was also deferreduntil the completion of the above-mentioned promotional activities.  As discussed above, the revenue recognitioncriteria related to the sale of the *i*AN-8000equipment was satisfied in the first quarter of 2005 and as such, the revenuerelated to the chassis sale of $66.5 million has been reported in the quarterended March 31, 2005.  Deferredrevenue at March 31, 2005 was $5.8 million related to this agreement.

 

We have invested in SoftbankChina and Restructuring Fund No. 1, which is an investment vehicleestablished by SOFTBANK CORP. and its affiliates.  For additional information see “Note 13” toour condensed consolidated financial statements.

 

On July 17, 2003, weentered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”),an affiliate of SOFTBANK CORP. Under the terms of the agreement, we loaned BBModem $10.1 million at an effective interest rate of 12.01% per annum, for thepurpose of investing in a portfolio of ADSL modems and associated modem rentalagreements, from SBBC. SBBC will continue to service such modems and modem rentalagreements. Our loan is subordinated to certain senior lenders of BB Modem, andrepayments are payable to us over a 42-month period through January 31,2007, with a substantial portion of the principal amount of the loanscheduled to be repaid during the last 16 months of this period. Ourrecourse for nonpayment of the loan is limited to the assets of BB Modem, theaccount into which subscriber payments are made and its rights under thesecuritization transaction documents. The value of BB Modem’s modems that serveas collateral for the loan may decrease over time and may not be sufficientupon sale to pay the outstanding amounts on the loans. We assess the loan forimpairment whenever events or changes in circumstances indicate that thecarrying amount may not be recoverable. We periodically review the underlyingquality of the asset pool securing the loan to assess whether impairment hasincurred and needs to be recorded. During the three months ended March 31,2005 and 2004, we recorded $0.3 million and $0.4 million, respectively, ininterest income in respect to this loan. The loans receivable at March 31,2005 and December 31, 2004 were approximately $11.3 million and $11.8million, respectively and were included in other long-term assets.

 

On April 5, 2003, werepurchased 8.0 million shares of common stock beneficially owned bySOFTBANK America Inc., at a purchase price of $17.385 per share. The totalcost of the repurchase was $139.6 million including transaction fees. Inconnection with this repurchase transaction, SOFTBANK America Inc.entered into an agreement with us to not offer, sell or otherwise dispose of  our common stock for a period of one year,subject to a number of exceptions. As of March 31, 2005, SOFTBANKAmerica Inc. beneficially owned approximately 12.8% of our outstandingstock.

 

On August 29, 2002, wecompleted the repurchase of 6.0 million shares of our common stock for $72.9million from SOFTBANK America, Inc.

 

*CellonInternational*

 

In October 2002, weentered into a license and a royalty agreement with Cellon InternationalHolding Corporation (“Cellon”), in which we have a 9% ownership interest. Perthe terms of the royalty agreement, we are required to pay Cellon $3.00 perunit shipped for a minimum of 0.1 million units. This agreement is not materialto the overall financial results of Cellon. We have evaluated our relationshipwith Cellon under FIN 46, and determined that consolidation is not necessary.

 

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*Fiberxon*

 

We have an outstandingpurchase commitment with Fiberxon, in which we have an 11% ownership interest,to purchase component parts for optical networking products. We anticipate thatwe will be able to fulfill this commitment without adverse consequencesmaterial to our operations or financial condition. Purchases from Fiberxontotaled $5.0 million during the 3 months ended March 31, 2005. As of March 31,2005, we had $2.7 million in open purchase commitments and $1.9 million inaccounts payable to Fiberxon.

 

*StarcomProducts, Inc.*

 

We obtain engineeringconsulting and employee placement services from Starcom Products, Inc.(“Starcom”), which is 31% owned by an individual related to a member of ourBoard of Directors. We paid $1.1 million to Starcom in 2004.  We did not obtain any services from thisentity in the three months ended March 31, 2005.

 

**RESULTS OF OPERATIONS**

 

Ournet sales consist of product and service sales within three broadtelecommunications product families:  (i) wirelessinfrastructure, (ii) broadband infrastructure, and (iii) handsets andcustomer premise equipment. Wireless infrastructure is primarily comprised ofthe PAS and CDMA products. Broadband infrastructure is primarily comprised ofthe iAN-8000, IP-Based Digital Subscriber Line Access Multiplexer(“IP-DSLAM”) (“AN-2000”), GEPON, NetRingTM and other wireline products.The handsets and customer premise equipment products include PAS handsets, CPEand CDMA handsets that were introduced in the fourth quarter of 2004. With manyof our product sales, we provide installation services. Additionally, weprovide maintenance services for some of our products. We organize and operateour business in five operating segments principally based upon these threeproduct families, namely, Broadband, Wireless, Handsets, PCD and Services.  For each of the periods presented, totalservices sales accounted for less than 10% of net sales.  During the first quarter of 2005, we recorded$901.8 million in net sales, an increase of 45% compared to the correspondingquarter in 2004, and 21% compared to the fourth quarter of 2004.  Net sales may not grow at the same rate ormay even decline in the future.

 

Costof sales consists primarily of materials costs, fees to agents, costsassociated with manufacturing, assembly and testing of products, costsassociated with installation and customer training and overhead and warrantycosts. Cost of sales also includes import taxes and tariffs on components andassemblies. Some components and materials used in our products are purchasedfrom a single supplier or a limited group of suppliers and, in some cases, aresubject to our obtaining Chinese import permits and approvals. We also rely onthird party manufacturers to manufacture and assemble most of our handsets.

 

Ourgross profit has been affected by product mix, average selling prices andmaterial costs. Our gross profit, as a percentage of net sales, varies amongour product families. We expect that our overall gross profit, as a percentageof net sales, will fluctuate from period to period as a result of shifts inproduct mix, anticipated decreases in average selling prices and our ability toreduce cost of sales.

 

Selling,general and administrative expenses include compensation and benefits,professional fees, sales commissions, provision for doubtful accountsreceivable and travel and entertainment costs. A large percentage of our costsare fixed and are difficult to quickly reduce in periods of reduced sales. Weintend to pursue aggressive selling and marketing campaigns and to expand ourdirect sales organization, and, as a result, our sales and marketing expenseswill increase in future periods. We also expect that in support of ourglobalization transformation, we may continue to incur costs associated to thetransformation process.

 

Researchand development expenses consist primarily of salaries and related costs ofemployees engaged in research, design and development activities, costs ofparts for prototypes, equipment depreciation and third party developmentexpenses. A large percentage of our costs are fixed and are difficult toquickly reduce in periods of lower sales. We believe that continued investmentin research and development is critical to our long-term success.

 

Incometax expense is based upon a blended effective tax rate based upon ourexpectation of the amount of income to be earned in each tax jurisdiction. Theprimary drivers for income tax expense include both the total amount andgeographic source of the income earned. We use credits and other tax incentivesto minimize our income tax expense. Income tax expense as a percentage ofincome before taxes will increase if relatively more income is earned in highertax jurisdictions.

 

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**THREEMONTHS ENDED MARCH 31, 2005 AND 2004**

 

**NET SALES**

 

| ** **           | ** ** | **Three months ended March 31,** | ** ** |
|----------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **           | ** ** | **(in thousands)**                    | ** ** |
|                 |       |                                  |       |   |   |   |   |   |   |
| **Sales by  region** |       |                                  |       |   |   |   |   |   |   |
| Japan                |       | $                                     | 329,708    |   | 37% |   | $ | 19,427 |   | 3% |   |
| United  States       |       | 302,176                               |       | 33% |   | 17,372 |   | 3% |   |
| China                |       | 227,209                               |       | 25% |   | 570,566 |   | 92% |   |
| Other                |       | 42,702                                |       | 5% |   | 14,927 |   | 2% |   |
| **TOTAL  NET SALES** |       | $                                     | 901,795    |   | 100% |   | $ | 622,292 |   | 100% |   |

 

## ***Three months ended March 31,2005 and 2004***

## *** ***

Netsales were $901.8 million in the three months ended March 31, 2005, up 45%from $622.3 million in the corresponding quarter of 2004.  The overall increase in net sales isprimarily due to the incremental sales derived from PCD, resulting from theselected assets we acquired from Audiovox in November 2004, as well as theincreased sales revenues recognized in the current quarter for revenuepreviously deferred relating to agreements with Japan Telecom.  Net sales revenue by geography shiftedsignificantly in comparison to the corresponding quarter 2004 and is attributablein part to our continuous efforts in growing our business internationally.

 

Aswe have been experiencing in the recent quarters, the demand of our PAS/iPASproducts including PAS/iPAS system based handsets in the China market continuedto mature which resulted in lower demand and average selling price.  As a general seasonality factor, businessactivity in China and many other countries in Asia decline considerably duringthe first quarter of each year in observance of the Lunar New Year. As aresult, sales during the first quarter of our fiscal year have typically beenlower than sales during the fourth quarter of the preceding year.  We recorded stronger sales revenue in ourBroadband Infrastructure segment for the three months ended March 31,2005, primarily due to recognition of revenue for products delivered to JapanTelecom in the third and fourth quarters of 2004  which had been previously deferred . Foradditional discussion see “Related Party Transactions – Softbank”. We do notexpect our broadband infrastructure sales to maintain this pace in the future.

 

Netsales increased in our Broadband Infrastructure and Service segments, anddeclined in the other three segments in the three months ended March 31,2005, compared to the corresponding quarter in fiscal 2004.  For additional discussion see SegmentReporting.

 

We group all of our Chinacustomers together by province and treat each province as one customer sincethat is the level at which purchasing decisions are made. At March 31,2005 and 2004, we had 30 and 31 such customers, respectively. No provinceexceeded 10% of our net sales for the three months ended March 31, 2005.The Guangdong province accounted for 24% of our net sales for the three monthsended March 31, 2004.

 

**GROSSPROFIT**

 

| ** **               | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **               | ** ** | **(in thousands)**                    | ** ** |
|                     |       |                                  |       |   |   |
| Gross profit             |       | $                                     | 238,189    |   | $ | 176,034 |   |
| Gross profit  percentage |       | 26                                    | %          | 28 | % |
|                          |            |                                       |            |  |  |  |  |

 

### *Threemonths ended March 31, 2005 and 2004*

### * *

Grossmargin was $238.2 million, or 26% of net sales, in the three months ended March 31,2005, compared to $176.0 million, or 28% of net sales, in the correspondingquarter of 2004. The gross profit increase can be attributed to increasedsales.  The overall gross

 

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profitpercentage decline can be attributed principally to the lower gross profitpercentages from our terminal products which includes PAS/iPAS based handsetsand handsets sales through PCD business. The continued pricing pressure throughout the telecommunications marketin China attributed to the lower gross profit of PAS/iPAS system basedhandsets.  In addition, handsets salesthrough PCD typically have lower gross margin, approximately 4%, than thoserealized on PAS/iPAS system based handsets. PCD contributed $13.7 million in gross margin for the three months endedMarch 31, 2005 and had no contribution in the corresponding quarter infiscal 2004 since PCD was not acquired until November 2004.

 

Theimprovement in gross profit as a percentage of net sales for our Broadbandoperating segment was primarily due to the increased economies of scaleresulting from larger orders.  We do notbelieve we can continue to improve our gross profit at this pace.  For additional discussion see “SegmentReporting”.

 

**OPERATINGEXPENSES**

 

The following table summarizesour operating expenses:

 

| ** **                                                           | ** ** | **Three months ended March 31,** | ** **  |
|----------------------------------------------------------------------|------------|---------------------------------------|-------------|
| ** **                                                           | ** ** | **2005**                              | ** **  | **% of net  sales** | ** ** | **2004** | ** ** | **% of net  sales** | ** ** |
| ** **                                                           | ** ** | **(in thousands)**                    | ** **  |
|                                                                 |       |                                  |        |   |   |   |   |   |   |
| Selling,  general and administrative (“SG&A”) expenses |       | $                                     | 108,210     |   | 12% |   | $ | 66,943 |   | 11% |   |
| Research and  development (“R&D”)                      |       | 66,660                                |        | 7% |   | 45,658 |   | 7% |   |
| Amortization  of intangible assets                                   |       | 6,972                                 |        | 1% |   | 2,973 |   | 1% |   |
|                                                                 |       |                                  |        |   |   |   |   |   |   |
| **TOTAL  OPERATING EXPENSES**                                        | ** ** | **$**                                 | **181,842** | ** ** | **20%** | ** ** | **$** | **115,574** | ** ** | **19%** | ** ** |
|                                                                      |            |                                       |             |  |  |  |  |  |  |  |  |  |

 

*SELLING,GENERAL AND ADMINISTRATIVE*

 

Selling, general andadministrative (“SG&A”) expenses were $108.2 million and $66.9 million inthe three months ended March 31, 2005 and the corresponding quarter offiscal 2004, respectively. We monitor SG&A as a percentage of net saleswhich was 12% and 11% of net sales in the three months ended March 31,2005 and in the corresponding quarter of 2004, respectively.

 

The increase in SG&Aexpenses in absolute dollars of $41.3 million was due to an increase inheadcount to support increased business volume including PCD operations whichdid not exist in the corresponding quarter in 2004, and an increase of $11.6million compared to the same quarter of 2004, due to longer collection cyclesin China.  Increased professional costs of $10.8 million are expensesassociated with the supply chain management, system integration andSarbanes-Oxley Act compliance projects.

 

*RESEARCHAND DEVELOPMENT*

 

Research and development(“R&D”) expenses were $66.7 million, or 7% of net sales, in the threemonths ended March 31, 2005, compared to $45.7 million , or 7% of netsales in the corresponding quarter of 2004.  We monitor R&D expensesas a percentage of net sales.  In the three months ended March 31,2005 this percentage was consistent compared to the corresponding quarter of2004.

 

The increase in absolutedollars of R&D expenses was due to increased headcount and related payrollexpenses of $9.3 million to support both product enhancements and new productdevelopment. In the three months ended March 31, 2005, R&D headcountincreased by approximately 900 employees as compared to the same period lastyear**resulting from our continuedexpansion of research and development teams in China of approximately 700employees and from 200 additional employees absorbed in relation to variousacquisitions.  In addition, the increasein R&D expenses also can be attributable to the increased professionalcosts of $7.3 million associated with outsourced projects driven by increasedsales activities in the three months ended March 31, 2005.  Depreciation and facility expenses alsoincreased by $2.5 million resulting from various acquisitions and internalgrowth in operations.  Lastly, we recorded a $2.2 million charge relating to the shut-down of HSIoperations which we acquired in April 2004.  We decided in the fourth quarter of 2004 tosubstantially abandon HSI’s legacy operation due to the difficultiesencountered in

 

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integrating the operations.  The charge of $2.2 million includes fixedassets write-off, costs associated with the termination of leases andpersonnel.

 

*AMORTIZATIONOF INTANGIBLE ASSETS*

 

The amortization ofintangible assets was $7.0 million in the three months ended March 31,2005 compared to $3.0 million for the same quarter last year.  The increasein amortization expense of intangible assets was due to additional amortizationexpenses related to $47.7 and $20.9 million of intangible assets recorded inconnection with our acquisitions in 2004 of Audiovox and TELOS, respectively, aswell as $3.1 million intangible assets related to the Giga acquisition in thefirst quarter of 2005. The estimated useful lives of these purchasedintangibles are from one to ten years.

 

*INTERESTINCOME*

 

Interest income was $1.3million and $1.4 million for the three months ended March 31, 2005 and2004, respectively. Interest income was generated from cash and short-terminvestment balances which remained consistent in the three months ended March 31,2005 and the corresponding quarter of 2004.

 

*INTERESTEXPENSE*

 

Interest expense was $4.3million and $1.1 million for the three months ended March 31, 2005 and2004, respectively.  The increase ininterest expense for the three months ended March 31, 2005 wasattributable to the increase in short-term borrowings in the form of bankloans.

 

*OTHERINCOME (EXPENSES)*

 

Net other income or expensewas an expense of $6.8 million and an income of $8.8 million for the threemonths ended March 31, 2005 and 2004, respectively. Net other expense forthe three months ended March 31, 2005 was primarily due to a $7.8 millionloss on foreign currency revaluation and offset by consumption tax refunds inJapan of $1.2 million, and a $0.5 million financial subsidy from the localChinese government.  Net other income for the three months ended March 31,2004 was primarily due to our receiving a $7.8 million financial subsidy fromthe local Chinese government.  This subsidy is to encourage our investmentin local research and development and manufacturing activities.  We alsorecorded a Japanese consumption tax refund of $1.4 million, offset by a $0.4million foreign exchange loss.

 

*INCOME TAXEXPENSE*

 

Income tax expense was $7.9million and $13.7 million for the three months ended March 31, 2005 and2004, respectively.  Our 2005 annualeffective tax rate is estimated to be 27% which would have resulted in a $12.6million tax expense for the three months ended March 31, 2005.   The $4.7 million difference between theexpected tax expense of $12.6 million and actual tax expense of $7.9 million isattributable to an increase in deferred tax assets.  The increase in deferred tax assets is due toan assessment of a local income tax for two entities in China.  The difference between the U.S. statutoryrate of 35% and the 2005 estimated rate of 27% is attributable to expectedutilization of operating losses, permanent tax deductions related to ourconvertible debt offering in 2003 and lower tax rates in various jurisdictionswe operate in, partially offset by application of state income taxes.

 

*EQUITY INNET LOSS OF AFFILIATED COMPANIES*

 

Equity in net loss ofaffiliated companies was $0.5 million and $1.0 million for the three monthsended March 31, 2005 and 2004, respectively and primarily resulted fromthe losses incurred by our joint venture with Matsushita CommunicationIndustrial Co., Ltd., and was partially offset by the gain recognized onour investment in Restructuring Fund.

 

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SEGMENTREPORTING

 

Wehistorically managed our business as a single reportable segment. During 2004,we continued to expand our focus on markets and operations outside of China.Effective with the fourth quarter of 2004, it was determined that our chiefoperating decision makers, in accordance with SFAS No. 131, “Disclosuresabout Segments of an Enterprise and Related Information,” were evaluatingperformance, making operating decisions and allocating resources based on twooperating segments: i) China and ii) all other regions referred to asInternational (“International”).

 

OnNovember 1, 2004, we acquired selected assets of the wireless handsetdivision of Audiovox Corporation. The acquired business has been integratedinto our operation as a separate and distinct operating division referred to asthe Personal Communications Division, (“PCD”). As we determined to evaluateperformance and allocate resources to this division, it was considered a thirdoperating segment.

 

Asa result, as of December 31, 2004, we were organized, principally based ongeographical market locations, in three operating segments, China,International and PCD, and each segment consisted of one reporting unit.

 

Effectivein the first quarter of 2005, we decided to reorganize our business basedprincipally upon product lines and realigned our business into five operatingunits, namely Broadband Infrastructure, Wireless Infrastructure, Handsets, PCD,and Global Service Solutions.  Eachoperating unit represents its own reporting segment and each operating unit isresponsible for its own production and sales management.

 

Wecurrently evaluate operating performance of and allocate resources to thereporting segments based on segment gross profit.  Cost of sales and direct expenses in relationto production are assigned to the reporting segments.  Corporate headquarters expenses andnon-operating items are not allocated to the segments.  The accounting policies used in measuringsegment assets and operating performance are the same as those used by  corporate and are consistantly applied acrossall segments.

 

Summarizedbelow are our segment sales revenue and gross profit for the three months endedMarch 31, 2005 and 2004, respectively. For the three months ended March 31, 2005, the Broadband segment includedrelated party sales and gross profit of $283.0 million and $157.0 million,respectively.  In addition, for the threemonths ended March 31, 2005, the Service segment included related party revenueand gross profit of $12.6 million associated with promotional services.

 
| ** **                       | ** ** | **Three months ended March 31, 2005** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| **Sales by segment**             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Revenue from external  customers |       | $                                          | 324,917    |   | $ | 109,951 |   | $ | 128,083 |   | $ | 315,552 |   | $ | 23,292 |   | $ | 901,795 |   |
| Gross profit                     |       | 163,515                                    |       | 30,190 |   | 14,539 |   | 13,692 |   | 16,253 |   | 238,189 |   |
|                                  |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Three months ended March 31, 2004** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| **Sales by segment**             |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Revenue from external  customers |       | $                                          | 36,700     |   | $ | 336,517 |   | $ | 236,442 |   | — |   | $ | 12,633 |   | $ | 622,292 |   |
| Gross profit                     |       | 16,889                                     |       | 152,236 |   | 2,562 |   | — |   | 4,347 |   | 176,034 |   |
|                                  |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **              | ** ** | **As of March 31, 2005** | ** ** |
|-------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **Broadband**                 | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total long-lived assets |       | $                             | 56,723     |   | $ | 96,882 |   | $ | 54,423 |   | $ | 1,183 |   | $ | 69,276 |   | $ | 278,487 |   |
| Total assets            |       | 831,845                       |       | 961,365 |   | 716,828 |   | 467,643 |   | 89,371 |   | 3,067,052 |   |
|                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **              | ** ** | **As of December  31, 2004** | ** ** |
|-------------------------|------------|-----------------------------------|------------|
| ** **              | ** ** | **Broadband**                     | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total long-lived assets |       | $                                 | 50,454     |   | $ | 106,003 |   | $ | 46,325 |   | $ | 1,330 |   | $ | 64,647 |   | $ | 268,759 |   |
| Total assets            |       | 1,018,608                         |       | 1,184,649 |   | 676,022 |   | 363,298 |   | 73,428 |   | 3,316,005 |   |
|                         |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Long-lived assets bygeographical areas are as follows (in thousands):

 

| ** **                  | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| U.S.                        |       | $                        | 22,968     |                        | $          | 24,958 |   |
| China                       |       | 242,996                  |       | 229,469                     |       |
| Other                       |       | 12,523                   |       | 14,332                      |       |
| **Total long-lived assets** |       | $                        | 278,487    |                        | $          | 268,759 |   |

 

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*Broadband Infrastructure*

 

Revenue from externalcustomers for this operating segment was $324.9 million in the three monthsended March 31, 2005, as compared to $36.7 million in the correspondingquarter in 2004.  The strong increase innet sales was due to the completion of revenue recognition of certain of theagreements entered into with Japan Telecom that had been recorded as deferredrevenue in prior quarters.

 

Gross profit from externalcustomers for the segment was $163.5 million in the three months ended March 31,2005, as compared to $16.9 million in the corresponding quarter in 2004.  The gross margin improvement, both inabsolute dollars and as a percentage of net sales, in the three months ended March 31,2005 was largely due to the increased economies of scale resulting from largerorders relating to the Japan Telecom agreements. In addition, the product mixalso contributed to the higher gross profit for the three months ended March 31,2005.  We do not expect our sales toJapan Telecom to maintain this pace in the future.

 

*Wireless Infrastructure*

 

Revenue from externalcustomers for this operating segment was $110.0 million in the three monthsended March 31, 2005, as compared to $336.5 million in the correspondingquarter in 2004. The decrease in net sales primarily is a result of ourcustomers in China transitioning from new system installations to systemexpansions as PAS/iPAS systems reach product maturity.

 

Gross profit from externalcustomers for this operating segment totaled $30.2 million in the three monthsended March 31, 2005, as compared to $152.2 million in the correspondingquarter in 2004.  The gross profit inabsolute dollars and as a percentage of net sales both declined in the threemonths ended March 31, 2005. The decline in gross profit is attributableto the lower sales and continued pricing pressure throughout the telecommunicationsmarket in China.

 

*Handsets*

 

Revenue from externalcustomers in the PAS/iPAS systems Handsets operating segment totaled $128.1million in the three months ended March 31, 2005 as compared to $236.4million in the corresponding quarter of 2004. The decrease in net sales wasprimarily attributable to pricing pressure in the China telecommunicationsmarket since the later part of 2004.  Theprice erosion continued to contribute to the downward gross profit for the handsetsegment in the three months ended March 31, 2005.

 

*PCD*

 

Revenue from externalcustomers for the segment was $315.6 million in the three months ended March 31,2005. No revenue was recorded in the corresponding quarter last year due to thefact that the acquisition of ACC and the creation of PCD did not occur until November 2004.

 

Gross profit from externalcustomers for the segment was $13.7 million in the three months ended March 31,2005. The gross profit as a percentage of net sales recognized on handset salesthrough PCD is typically lower than that realized on PAS/iPAS systems basedhandsets.

 

*Service*

 

Service Revenue fromexternal customers for this operating segment was $23.3 million in the threemonths ended March 31, 2005 as compared to $12.6 million in thecorresponding quarter last year.  TheService segment for the quarter ended March 31, 2005 includes $12.6 million ofrevenue and gross profit associated with promotional services.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

*Operating Activities*

 

*2005*

 

Net cash used in operatingactivities for the three months ended March 31, 2005 was $182.9 million.Operating cash was affected by changes in accounts receivable, inventory andcustomer advances offset by changes in accounts payable and deferred revenue.

 

The $118.2 million increasein accounts receivable was attributable to incremental sales derived from PCDsales and longer China

 

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collection cyclesexperienced during the three months ended March 31, 2005 as compared tothe same quarter in the prior year.  Days sales outstanding was 119 daysexcluding PCD, or 90 days including PCD, at March 31, 2005 as compared to63 days at March 31, 2004.  Also contributing to the increase was alarger volume of sales, from $901.8 million for the three months ended March 31,2005 compared to $622.3 million for the same quarter in 2004.  The longer days sales outstanding is a directresult of slower collection cycles in China due to the recent slow-down in theeconomy.  We do not expect a significantimprovement to shorten days sales outstanding in the near future.

 

Inventory increased by $15.7million, due to the increase in sales volume noted above. We will continue tobuild our total inventory supply to meet the anticipated demand in futureperiods.

 

Customer advances decreasedby $227.9 million for the three months ended March 31, 2005. Customer advances represent cash deposits we have received from our customersfor orders that have not yet received final acceptance. Upon subsequent receiptof final acceptances and revenue recognition, customer advances are reduced andrevenue and cost of sales is recorded.  The reduction of customer advancesin the three months ended March 31, 2005 was primarily due to thecompletion of the revenue earning process for most of the agreements with JapanTelecom, Inc. (“JT”), an affiliate of Softbank Corp. All cash receivedfrom JT in advance of revenue recognition and in advance of spending forpromotional activities was reflected as a customer advance in priorperiods.  Revenue for certain of these agreements has been recognized inthe three months ended March 31, 2005.  For additional information,refer to Note 19, “Related Party Transactions”, to our condensed consolidatedfinancial statements.

 

Offsetting the activity thatdecreased operating cash for the period were net income and non-cash charges,including $25.9 million of depreciation and amortization, $17.5 million ofprovision for doubtful accounts and $15.2 million of inventoryprovision.   Accounts payable increased by $33.4 million, deferredrevenue increased by $30.2 million and other current and non-current assetsdecreased by $49.7 million, all of which contributed to the increase inoperating cash.

 

*2004*

 

Netcash used in operating activities for the three months ended March 31,2004 was $27.3 million. Operating cash was affected by changes in accountsreceivable, inventory and customer advances offset by changes in deferred costsand accounts payable.  The lower level of business activity resulting fromtypical winter seasonality and from the Chinese New Year impacted our operatingcash for the first quarter of 2004, consistent with comparative periods inprior years. The $69.9 million increase in accounts receivable was, in part,attributable to lower cash collections due to the Chinese New Year and theresulting decreased activity level. Inventory increased by $70.5 million, alsodecreasing our operating cash.  As we expect sales to increase insubsequent quarters, we built our inventory supply in this period to meet theanticipated demand in future periods.  The $156.4 million decrease incustomer advances also decreased operating cash for the period.  Customeradvances, which represent cash deposits we have received from our customers fororders that have not yet received final acceptance, decreased due to anincreased amount of customer acceptances.  Offsetting the activity thatdecreased operating cash for the period were changes in deferred costs andaccounts payable. Deferred costs, or inventory at customer sites awaiting finalacceptance, decreased by $132.7 million.  The decrease in deferred costswas also a result of increased revenues and a greater number of customeracceptances, corresponding to the decrease in customer advances.  Accountspayable increased by $36.8 million, due to increased inventory purchasing.

 

*InvestingActivities*

 

*2005*

 

Net cash provided byinvesting activities for the three months ended March 31, 2005 totaling$79.1 million was primarily due to $120.1 million of proceeds from the net saleof short-term investments which was used to pay down our borrowings.  Cashoutflows from investing activities included our purchase of the selected assetsof Giga, which resulted in a cash outflow of $18.5 million as well as $28.3million invested in property, plant and equipment.

 

*2004*

 

Netcash used in investing activities for the three months ended March 31,2004 of $28.0 million was primarily due to purchases of property, plant andequipment to support our expansion.  $12.4 million of the total $27.7million in property, plant and equipment purchases were construction costsincurred on our Hangzhou manufacturing facility.  Additional investingactivities include an additional $1.0 million investment in Fiberxon, offset bynet proceeds from the sale of short-term investments of $0.9 million.

 

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*FinancingActivities*

 

*2005*

 

Net cash used in financingactivities was $83.3 million for the repayment of short-term borrowings inexcess of new borrowing for the three months ended March 31, 2005.

 

We received $0.7 millionfrom the issuance of common stock through the exercise of stock options for thethree months ended March 31, 2005.

 

*2004*

 

Netcash provided by financing activities was $405.6 million for the three monthsended March 31, 2004.  This was primarily due to proceeds raised fromour selling 12.1 million shares of common stock at $39.25 per share to Banc ofAmerica Securities, LLC, for net proceeds of approximately $474.6 million. Inaddition to the sale of stock, we received $9.2 million for the issuance ofcommon stock through stock option exercises. Offsetting cash provided byoperating activities, we used a portion of the capital raised to repurchase atotal of 2.6 million shares of our common stock at an average price of $30.43per share for a total cost of $78.2 million, including transaction fees.

 

*Liquidity*

 

Our working capital was $1.1billion and $1.3 billion at March 31, 2005, and 2004, respectively.  This decrease in working capital mainly consistsof a decrease in cash on hand, to $372.7 million in cash and cash equivalentsand $16.2 million of short term in investments at March 31, 2005, from$728.7 million of cash and cash equivalents and $41.3 million of short-terminvestments at March 31, 2004.  Thedecease in working capital was also due to higher balances in accounts andnotes payable and offset by higher accounts receivable balances.  The decrease in working capital is primarilyattributable to the funding of a series of acquisitions completed in the past12 months.

 

Our China sales aregenerally denominated in local currency. Due to the limitations on convertingRenminbi, we are limited in our ability to engage in foreign currency hedgingactivities in China. We cannot guarantee that fluctuations in foreign currencyexchange rates in the future will not have a material adverse effect onrevenues from international sales and, correspondingly, on our business,financial condition and results of operations. We have contracts negotiated in JapaneseYen and we maintain a bank account in Japanese Yen for purchasing portions ofour inventories and supplies. The balance of this Japanese Yen account at March 31,2005 was approximately $97.1 million. We hedge certain Japanese Yen-denominated balance sheet exposuresagainst future movements in foreign currency exchange rates by using foreigncurrency forward contracts. Gains and losses on these fair value hedges areintended to offset gains and losses from the revaluation of our JapaneseYen-denominated recognized liabilities. In accordance with Statement ofFinancial Accounting Standards No. 133 (“SFAS 133”), “Accounting forDerivative Instruments and Hedging Activities,” we recognize derivativeinstruments and hedging activities as either assets or liabilities on thebalance sheet and measure them at fair value. Our foreign currency forwardcontracts generally mature within three months. We do not intend to utilizederivative financial instruments for speculative trading purposes.

 

We accept bank notesreceivable and commercial notes receivable with maturity dates of between threeand six months from our customers in China in the normal course of business.Notes receivable available for sale was $22.9 million and $27.0 million atMarch 31, 2005 and December 31, 2004, respectively. We may discountthese notes with banking institutions in China. Any notes that have been soldare not included in our consolidated balance sheets as the criteria for saletreatment established by Statement of Financial Accounting Standards No. 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishmentof Liabilities” (“SFAS 140”), have been met.

 

In March 2003, wecompleted an offering of $402.5 million of convertible subordinated notesdue March 1, 2008 to qualified institutional buyers pursuant to Rule 144Aunder the Securities Act of 1933, as amended. The notes bear interest at a rateof 7/8% per annum and are convertible into our commonstock at a conversion price of $23.79 per share and are subordinated to all ofour present and future senior debt. Concurrent with the issuance of the convertible notes, we entered into aconvertible bond hedge and a call option transaction with respect to our commonstock. Both the bond hedge and call option transactions may be settled at ouroption either in cash or net shares and expire on March 1, 2008.

 

We believe that our existingcredit facilities and cash and cash equivalents, short-term investments andcash from operations will be

 

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sufficient to finance ouroperations and any cash used for planned restructuring activities through atleast the next 12 months. As of March 31, 2005, we had cash, restrictedcash, short-term investments and restricted short-term investments of $418.5million and lines of credit totaling $487.5 million available for futureborrowings, $480.3 million of these expire in 2005 and $7.2 million of thesefacilities expire in 2010.  We are proceeding with the extension orrenewal of these credit facilities, however, our ability to obtain such renewalor extension is not certain.   Of our total cash and short-term investmentbalance, $158.3 million is held in China where currency exchange controlsexist.  As a result, our ability to make payments in other jurisdictionscould be limited by our ability to move money from China to the otherjurisdictions**.**

 

In the event that ourcurrent cash balances, future cash flows from operations and current lines ofcredit are not sufficient to meet our obligations or strategic needs or in theevent that market conditions are favorable, we would consider raisingadditional funds in the capital or equity markets. If additional financing isneeded, there can be no assurance that such financing will be available to uson commercially reasonable terms, or at all.

 

*Incometaxes*

 

Certain subsidiaries andjoint ventures located in China enjoy tax benefits in China which are generallyavailable to foreign investment enterprises, including full exemption fromnational enterprise income tax for two years starting from the first profit-makingyear and/or a 50% reduction in national income tax rate for the following threeyears. In addition, local enterprise income tax is often waived or reducedduring this tax holiday/incentive period. Under current regulations in China,foreign investment enterprises that have been accredited as technologicallyadvanced enterprises are entitled to additional tax incentives. These taxincentives vary in different locales and could include preferential nationalenterprise income tax treatment at 50% of the usual rates for different periodsof time. The tax holidays discussed above are applicable or potentiallyapplicable to CUTS, HUTS, Hangzhou UTStarcom Telecom Co., Ltd. (“HSTC”) and UTStarcomChina Co., Ltd. (“UTSC”), our active subsidiaries in China, as those entitiesmay qualify as accredited technologically advanced enterprises.

 

Income tax expense was $7.9million and $13.7 million for the three months ended March 31, 2005 and 2004, respectively.  Our 2005 annual effective tax rate isestimated to be 27% which would have resulted in a $12.6 million tax expensefor the three months ended March 31, 2005.  The $4.7 million difference between the expected tax expense of $12.6million and actual tax expense of $7.9 million is attributable to an increasein deferred tax assets.  The increase indeferred tax assets is due to an assessment of a local income tax for twoentities in China.

 

We are working toimplement a research and development cost sharing arrangement among our keyworldwide entities. The purpose of cost sharing is to enable its participantsto jointly develop and own intangibles. Under research and development costsharing, the total research and development expense is paid by cost-sharingparticipants in proportion to each participant’s future sales. The benefit isthat there is greater certainty with respect to transfer pricing and definedownership of IP. Cost sharing in China is a new concept and we are workingclosely with the China Tax and Regulatory Authorities to gain approval for costsharing.

 

*Contractualobligations and other commitments*

 

Our obligations undercontractual obligations and commercial commitments are as follows:

 

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| ** **                             | ** ** | **March 31, 2005  Payments Due by Period** | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| **(in thousands)**                     | ** ** | **Total**                                  | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **over 5 years** | ** ** |
|                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Notes Payable                          |       | $                                          | 1,330      |   | $ | 1,330 |   | $ | — |   | $ | — |   | $ | — |   |
| Bank Loans                             |       | $                                          | 274,155    |   | $ | 274,155 |   | $ | — |   | $ | — |   | $ | — |   |
| Convertible Subordinated Notes         |       | $                                          | 402,500    |   | $ | — |   | $ | 402,500 |   | $ | — |   | $ | — |   |
| Interest payable on Subordinated Notes |       | $                                          | 10,566     |   | $ | 1,761 |   | $ | 8,805 |   | $ | — |   | $ | — |   |
| Operating leases                       |       | $                                          | 43,350     |   | $ | 19,027 |   | $ | 17,141 |   | $ | 4,538 |   | $ | 2,644 |   |
| Standby letters of credit              |       | $                                          | 29,808     |   | $ | 27,226 |   | $ | 2,582 |   | $ | — |   | $ | — |   |

 

***Notes payable***

 

Occasionally, we issueshort-term notes payable to our vendors in lieu of trade accountspayable.  The payment terms are normally three to nine months and aretypically non-interest bearing.

 

***Bank loans***

 

At March 31, 2005, we had loanswith various banks totaling $266.0 million with interest rates ranging from3.04% to 4.35% per annum.  These bankloans mature during 2005 and are included in short-term debt.

 

We have a bank loan inconnection with an equipment purchase resulting from the consolidation of MDCHolding Limited and its affiliated entities (“MDC”).  On January 10, 2003, a third partyestablished a bank loan with Shanghai Pudong Development Bank for the purchaseof the equipment.  The obligations of thebank loan and related equipment were assumed by us on January 23, 2003, andsubsequently transferred to MDC on December 31, 2003.  The bank loan of $8.2 million bears interestat a rate of 4.94% per annum, and expires on January 10, 2006.  We do not serve as legal obligor for theloan.

 

***Convertible subordinated notes***

 

Our $402.5 million ofconvertible subordinated notes, due March 1, 2008, bear interest at a rateof 7/8% per annum, payable semiannually on May 1 and September 1, areconvertible into our common stock at a conversion price of $23.79 per share andare subordinated to all our present and future senior debt. The principal isdue only at maturity of the notes.

 

***Operating leases***

 

We lease certain facilitiesunder non-cancelable operating leases that expire at various dates through 2023.

 

***Standby letters of credit***

 

We issue standby letters ofcredit primarily to support international sales activities outside of China.When we submit a bid for a sale, often the potential customer will require thatwe issue a bid bond or a standby letter of credit to demonstrate our commitmentthrough the bid process. In addition, we may be required to issue standbyletters of credit as guarantees for advance customer payments upon contractsigning or performance guarantees. The standby letters of credit usually expiresix to twelve months from date of issuance without being drawn by thebeneficiary thereof.

 

***Purchase commitments***

 

We are obligated to purchaseraw materials and work-in-process inventory under various orders from various suppliers,all of which should be fulfilled without adverse consequences material to ouroperations or financial condition. As of March 31, 2005 total open commitmentsunder these purchase orders were approximately $317.9 million.

 

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***Investment commitments***

 

As of March 31, 2005, we hadinvested a total of $2.0 million in Global Asia Partners L.P. that isrecorded as a long-term investment. The fund size is anticipated to be$10.1 million and the fund was formed to make private equity investmentsin private or pre-IPO technology and telecommunications companies in Asia. Wehave a commitment to invest up to a maximum of $5.0 million. The remainingamount is due at such times and in such amounts as shall be specified in one ormore future capital calls to be issued by the general partner.

 

***Intellectual property***

 

Certain sales contractsinclude provisions under which customers would be indemnified by us in theevent of, among other things, a third-party claim against the customer forintellectual property rights infringement related to our products. There are nolimitations on the maximum potential future payments under these guarantees. Wehave not accrued any amounts in relation to these provisions as no such claimshave been made and we believe we have valid enforceable rights to theintellectual property embedded in our products.

 

**RECENTACCOUNTING PRONOUNCEMENTS**

 

InDecember 2004, the Financial Accounting Standards Board, “FASB” issued SFAS No.123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”).  SFAS 123(R) will require the Company tomeasure all employee stock-based compensation awards using a fair value methodand record such expense in its consolidated financial statements.  In addition, the adoption of SFAS 123(R) willrequire additional accounting related to the income tax effects and additionaldisclosure regarding the cash flow effects resulting from share-based paymentarrangements.

 

InMarch 2005, the Securities and Exchange Commission (the “SEC”) issued StaffAccounting Bulletin no. 107 (“SAB 107”) which provides guidance regarding theapplication of SFAS 123(R). SAB 107 expresses views of the staff regarding theinteraction between SFAS No. 123(R), Share-Based Payment, and certain SEC rulesand regulations and provides the staff’s views regarding the valuation ofshare-based payment arrangements for public companies. In particular, SAB 107provides guidance related to share-based payment transactions with non employees,the transition from nonpublic to public entity status, valuation methods(including assumptions such as expected volatility and expected term), theaccounting for certain redeemable financial instruments issued undershare-based payment arrangements, the classification of compensation expense,non-GAAP financial measures, first-time adoption of SFAS 123(R) in an interimperiod, capitalization of compensation cost related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentarrangements upon adoption of SFAS 123(R), the modification of employee shareoptions prior to adoption of SFAS 123(R) and disclosures in Management’sDiscussion and Analysis subsequent to adoption of SFAS 123(R).

 

On April 14, 2005, the SEC approveda new rule that delays the effective date for SFAS 123(R) to annual periodsbeginning after June 15, 2005.  Theadoption of SFAS 123(R) on January 1, 2006 is expected to have a materialimpact on the Company’s consolidated results of operations, financial positionand statement of cash flows.  The Companyis evaluating the transition method and pricing model alternatives uponadoption.

 

In December 2004, the FASBissued FSP No. FAS 109-2, “Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provision within the American Jobs Creation Act of2004.”  The American Jobs Creation Act of2004 provides a one-time 85% dividends received deduction for certain foreignearnings that are repatriated under a plan for reinvestment in the UnitedStates, provided certain criteria are met. FSP No. FAS 109-2 is effective immediately and provides accounting anddisclosure guidance for the repatriation provision.  FSP No. FAS 109-2 allows companies additionaltime to evaluate the effects of the law on its unremitted earnings for thepurpose of applying the “indefinite reversal criteria” under APB Opinion No.23, “Accounting for Income Taxes- Special Areas,” and requires explanatorydisclosures from companies that have not yet completed the evaluation.  We are currently evaluating the effects ofthe repatriation provision and their impact on our consolidated financialstatements.  We do not expect to completethis evaluation before the end of 2006. The range of possible amounts of unremitted earnings that is beingconsidered for repatriation under this provision is between zero and $540million and the related potential range of income tax is between zero and $28million.

 

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**FACTORS AFFECTING FUTURE OPERATING RESULTS**

 

**RISKS RELATED TO OUR COMPANY**

 

*Our future product sales areunpredictable and, as a result, our operating results are likely to fluctuatefrom quarter to quarter.*

 

Ourquarterly and annual operating results have fluctuated in the past and arelikely to fluctuate in the future due to a variety of factors, some of whichare outside of our control. Factors that may affect our future operatingresults, in addition to those described below, include:

 

•                                          the timing and size of the orders for our products;

 

•                                          changes in our customers’ subscriber growthrate;

 

•                                          the lengthy and unpredictable sales cyclesassociated with sales of our products;

 

•                                          cancellation, deferment or delay inimplementation of large contracts;

 

•                                          issues that might arise from the integrationof acquired entities or the inability to achieve expected results from suchacquisitions;

 

•                                          revenue recognition, which is based onacceptance, is unpredictable;

 

•                                          a seasonal reoccurrence of an outbreak ofsevere acute respiratory syndrome (“SARS”) or other illnesses;

 

•                                          the decline in business activity we typicallyexperience during the Lunar New Year, which leads to decreased sales during our  first fiscal quarter;

 

•                                          changes in accounting rules, such asrecording expenses related to employee stock option compensation plans; 

 

•                                          shift in our product mix or market focus; and

 

•                                          quality issues resulting from the design ormanufacture of the products, or from the software used in the product.

 

Asa result of these and other factors, period-to-period comparisons of ouroperating results are not necessarily meaningful or indicative of futureperformance. In addition, the factors noted above may make it difficult for usto forecast and provide in a timely manner public guidance (including updates toprior guidance) related to our projected financial performance of the Company.Furthermore, it is possible that in some future quarters our operating resultswill fall below the expectations of securities analysts or investors. If thisoccurs, the trading price of our common stock could decline.

 

*Competition in our markets maylead to reduced prices, revenues and market share.*

 

Wehave experienced intense competition in the past years, and we believe that wewill continue to face intense competition from both domestic and internationalcompanies in our target markets, many of which may operate under lower coststructures or may be given preferential treatment by applicable governmentalregulators and policies and have much larger sales forces than we do. Additionally,other companies not presently offering competing products may also enter ourtarget markets. Many of our competitors have significantly greater financial,technical, product development, sales, marketing and other resources than wedo. As a result, our competitors may be able to respond more quickly to new oremerging technologies and changes in service provider requirements. Ourcompetitors may also be able to devote greater resources than we can to thedevelopment, promotion and sale of new products. These competitors may be ableto offer significant financing arrangements to service providers, which maygive them a competitive advantage in selling systems to service providers withlimited financial and currency resources. In many of the developing markets inwhich we operate or intend to operate, relationships with local governmentaltelecommunications agencies are important to establish and maintain. In manysuch markets, our competitors may have or be able to establish betterrelationships with local governmental telecommunications agencies than we have,which could result in their ability to influence governmental policy formationand interpretation to their advantage. Additionally, our competitors might havebetter relationships with their third party suppliers and 

 

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obtaincomponent parts at a reduced rate, allowing them to offer their end products atreduced prices. Moreover, the telecommunications and cable industries haveexperienced significant consolidation, and we expect this trend to continue. Ifwe have fewer significant customers, we may be more reliant on such largecustomers and our bargaining position and profit margins may suffer. Increasedcompetition is likely to result in price reductions, reduced gross profit as apercentage of net sales and loss of market share, any one of which couldmaterially harm our business, financial condition, cash flows, and results ofoperations.

 

*If we seek to secure additional financing and are notable to do so, our ability to expand strategically may be limited. If we areable to secure additional financing, our stockholders may experience dilutionof their ownership interest, or we may be subject to limitations on ouroperations and increased leverage.*

* *

Wecurrently anticipate that our available cash resources, which include existingcash and cash equivalents, short-term investments and cash from operations,will be sufficient to meet our anticipated needs for working capital andcapital expenditures for the foreseeable future. If we are unable to generatesufficient cash flows from operations, we may need to raise additional funds todevelop new or enhanced products, respond to competitive pressures, takeadvantage of acquisition opportunities or raise capital for strategic purposes.If we raise additional funds through the issuance of equity securities, ourstockholders will experience dilution of their ownership interest, and thenewly issued securities may have rights superior to those of common stock. Ifwe raise additional funds by issuing debt, we may be subject to limitations onour operations and increase our leverage. For example, in connection with thesale of convertible debt securities in March 2003, we incurred $402.5 millionof indebtedness. As a result of this indebtedness, our principal and interestpayment obligations have increased substantially. The degree to which we areleveraged could materially and adversely affect our ability to obtain financingfor working capital, acquisitions or other purposes and could make us morevulnerable to industry downturns and competitive pressures. Our ability to meetour debt service obligations will be dependent upon our future performance,which will be subject to financial, business and other factors affecting ouroperations, many of which are beyond our control. Finally, we are not certainthat we can maintain our existing unsecured credit line available to our Chinaoperations or additional sources of financing may not be available on reasonableterms or at all if and when we require it, which could harm our business.

 

*The average selling prices of our products maydecrease, which may reduce our revenues and our gross profit. As a result, wemust introduce new products and reduce our costs in order to maintainprofitability.*

* *

Theaverage selling prices for communications access and switching systems andhandsets have historically declined as a result of a number of factors,including:

 

•                                          increased competition;

 

•                                          aggressive price reductions by competitors;

 

•                                          rapid technological change; and

 

•                                          constant change in customer buying behaviorand market trends.

 

Theaverage selling prices of our products may continue to decrease in the futurein response to product introductions by us or our competitors or other factors,including price pressures from customers. Certain of our products, includingwireless handsets, have historically had low gross profit margins, and anyfurther deterioration of our profit margins on such products could result inlosses with respect to such products. Therefore, we must continue to developand introduce new products and enhancements to existing products thatincorporate features that can be sold at higher average selling prices. Failureto do so could cause our revenues and gross profit to decline.

 

Ourcost reduction efforts may not allow us to keep pace with competitive pricingpressures or lead to improved gross profit, as a percentage of net sales. Inorder to be competitive, we must continually reduce the cost of manufacturingour products through design and engineering changes. We may not be successfulin these efforts or in delivering our products to market in a timely manner. Inaddition, any redesign may not result in sufficient cost reductions to allow usto reduce the prices of our products to remain competitive or to improve ormaintain our gross profit, as a percentage of net sales, which would cause ourfinancial results to suffer.

 

*Sales in China have accounted for most of our totalsales, and our business, financial condition and results of operations are to asignificant degree subject to economic, political and social events in China.*

 

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Approximately$227.2 million, or 25%, and $570.6 million, or 92%, of our net sales in theperiods ended March 31, 2005 and 2004, respectively, occurred in China. Whilewe anticipate expansion into other markets, a significant portion of our netsales will be derived from China for the foreseeable future. In addition, weplan to continue to make further investments in China in the future. Therefore,our business, financial condition and results of operations are to asignificant degree subject to economic, political, legal and socialdevelopments and other events in China. Please read the risks detailed belowunder the heading “Risks Related to Conducting Business in China” foradditional information about the risks we face in connection with our Chinaoperations.

 

*Our market is subject to rapid technological change,and to compete effectively, we must continually introduce new products andproduct enhancements that achieve market acceptance.*

* *

Themarket for communications equipment is characterized by rapid technologicaldevelopments, frequent new product introductions and evolving industry andregulatory standards. Our success will depend in large part on our ability toenhance our network and broadband access and switching technologies and developand introduce new products and product enhancements that anticipate changing serviceprovider requirements and technological developments. We may need to makesubstantial capital expenditures and incur significant research and developmentcosts to develop and introduce new products and enhancements. If we fail todevelop and introduce new products or enhancements to existing products thateffectively respond to technological change on a timely basis, our business,financial condition and results of operations could be materially adverselyaffected. Certain of our products, including wireless handsets, have a shortproduct life. Moreover, from time to time, our competitors or we may announcenew products or product enhancements, technologies or services that have thepotential to replace or shorten the life cycles of our products and that maycause customers to defer purchasing our existing products, resulting ininventory reserve due to obsolescence. Future technological advances in thecommunications industry may diminish or inhibit market acceptance of ourexisting or future products or render our products obsolete.

 

Evenif we are able to develop and introduce new products, they may not gain marketacceptance. Market acceptance of our products will depend on various factors,including:

 

•                                          our ability to obtain necessary approvalsfrom regulatory organizations within the countries in which we operate and forany new technologies that we introduce;

 

•                                          the length of time it takes service providersto evaluate our products, causing the timing of purchases to be unpredictable;

 

•                                          our products being compatible with legacytechnologies and standards existing in previously deployed network equipment;

 

•                                          our ability to attract customers who may havepreexisting relationships with our competitors;

 

•                                          product cost relative to performance;

 

•                                          the level of customer service available tosupport new products; and

 

•                                          the timing of new product introductionsmeeting demand patterns.

 

Ifour products fail to obtain market acceptance in a timely manner, our businessand results of operations could suffer.

 

*We depend on some sole source and other keysuppliers, as well as international sources, for handsets, base stations,components and materials used in our products. If we cannot obtain adequatesupplies of high quality products at competitive prices or in a timely mannerfrom these suppliers or sources, or if the suppliers successfully market theirproducts directly to our customers, our competitive position, reputation andbusiness could be harmed.*

* *

Wehave contracts with a single supplier or with a limited group of suppliers topurchase some components and materials used in our products. If any supplier isunwilling or unable to provide us with high-quality components and materials inthe quantities required and at the costs specified by us, we may not be able tofind alternative sources on favorable terms, in a timely manner, or at all.Further, a supplier could market its products directly to our customers. Inparticular, our PCD is highly dependent on a single supplier for our handsetdevices. The possibility of a supplier marketing its own products would createdirect competition and may affect our ability to obtain adequate supplies. Ourinability to obtain or to develop alternative sources if and as required couldresult in delays or reductions in manufacturing or product shipments. From timeto time, there could be shortages of different products or components.Moreover, our suppliers may supply us with inferior quality products. If aninferior product supplied by a third party is embedded in 

 

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ourend product and causes a problem, it might be difficult to identify the sourceof the problem as being due to the component parts. If any of these eventsoccur, our competitive position, reputation and business could suffer.

 

Ourability to source a sufficient quantity of high-quality, cost-effectivecomponents used in our products may also be limited by import restrictions andduties in the foreign countries in which we manufacture our products. Werequire a significant number of imported components to manufacture ourproducts, and imported electronic components and other imported goods used inthe operation of our business may be limited by a variety of permitrequirements, approval procedures, import duties and registration requirements.Moreover, import duties on such components increase the cost of our productsand may make them less competitive.

 

*Product defects or performance quality issues couldcause us to lose customers and revenue or to incur unexpected expenses.*

* *

Manyof our products are highly complex and may have quality issues resulting fromthe design or manufacture of such product, or from the software used in theproduct. Often these issues are identified prior to the shipment of theproducts and may cause delays in market acceptance of our products, delays inshipping products to customers, or the cancellation of orders. In other cases,we may identify the quality issues after the shipment of products. In suchcases, we may incur unexpected expenses and diversion of resources to replacedefective products or correct problems. Such pre-shipment and post-shipmentquality issues could result in delays in the recognition of revenue, loss ofrevenue or future orders, and damage to our reputation and customerrelationships. In addition, we may be required to pay damages for failedperformance under certain customer contracts.

 

*Our recent growth has strained our resources, and ifwe are unable to manage and sustain our growth, our operating results will benegatively affected.*

* *

Wehave experienced a period of rapid growth and anticipate that we must continueto transform our operations to address market demands and potential marketopportunities. Our transformation has placed and will continue to place a significantstrain on our management, operational, financial and other resources. To manageour growth effectively, we will need to take various actions, including:

 

•                                          enhancing management information systems,including forecasting procedures;

 

•                                          further developing our operating,administrative, financial and accounting systems and controls;

 

•                                          managing our working capital and sources offinancing to fund our expansion;

 

•                                          maintaining close coordination among ourengineering, accounting, finance, marketing, sales and operationsorganizations;

 

•                                          expanding, training and managing our employeebase;

 

•                                          enhancing human resource operations andimproving employee hiring and training programs;

 

•                                          reorganizing our business structure to moreeffectively allocate and utilize our internal resources;

 

•                                          improving and sustaining our supply chaincapability;

 

•                                          managing the expansion of both our direct andindirect sales channels in a cost-efficient and competitive manner; and

 

•                                          fully reviewing our new customers’ credit historiesto ensure their financial stability before finalizing contracts.

 

Ifwe fail to implement or improve systems or controls or to manage any futuregrowth and expansion effectively, our business could suffer.

 

*Our success is dependent on continuing to hire andretain qualified personnel, and if we are not successful in attracting andretaining these personnel, our business will suffer.*

* *

Thesuccess of our business depends in significant part upon the continuedcontributions of key technical and senior management personnel, many of whomwould be difficult to replace. In particular, our success depends in large parton the knowledge, expertise and services of Hong Liang Lu, our Chairman of theBoard, President and Chief Executive Officer, Ying Wu, our Chairman and Chief

 

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ExecutiveOfficer of China Operations, and Philip Christopher, President and ChiefExecutive Officer of our PCD. The loss of any key employee, the failure of anykey employee to perform satisfactorily in his or her current position or ourfailure to attract and retain other key technical and senior managementemployees could have a significant negative impact on our operations.

 

Toeffectively manage our recent growth as well as any future growth, we will needto recruit, train, assimilate, motivate and retain qualified employees bothlocally and internationally. Competition for qualified employees is intense,and the process of recruiting personnel in all fields, including technology, researchand development, sales and marketing, administration and managerial personnelwith the combination of skills and attributes required to execute our businessstrategy can be difficult, time-consuming and expensive. As we grow globally,we must implement hiring and training processes that are capable of quicklydeploying qualified local residents to knowledgeably support our products andservices. Alternatively, if there is an insufficient number of qualified localresidents available, we might incur substantial costs importing expatriates toservice new global markets. For example, we have historically experienceddifficulty finding qualified accounting personnel knowledgeable in both U.S.and Chinese accounting standards who are Chinese residents. If we fail toattract, hire, assimilate or retain qualified personnel, our business would beharmed.

 

Competitorsand others have in the past, and may in the future, attempt to recruit ouremployees. In addition, companies in the telecommunications industry whoseemployees accept positions with competitors frequently claim that thecompetitors have engaged in unfair hiring practices. We may be the subject ofthese types of claims in the future as we seek to hire qualified personnel.Some of these claims may result in material litigation and disruption to ouroperations. We could incur substantial costs in defending ourselves againstthese claims, regardless of their merit.

 

*Any acquisitions that we undertake could bedifficult to integrate, disrupt our business, dilute our stockholders and harmour operating results.*

* *

Wehave acquired other businesses, products and technologies. For example, duringthe second quarter of 2004, we completed our acquisitions of TELOS and HSI for$30.0 million and $14.1 million, respectively. On November 1, 2004, wecompleted our selected asset acquisition of ACC for $165.1 million.Additionally, in January 2005, we completed the acquisition with Giga Telecom,Inc. to acquire certain assets related to the research and development of variousproducts. Any anticipated benefits of these acquisitions may not be realized.We have in the past and will continue to evaluate acquisition prospects thatwould complement our existing product offerings, augment our market coverage,enhance our technological capabilities, or that may otherwise offer growthopportunities. Acquisitions may result in dilutive issuances of equitysecurities, use of our cash resources, the incurrence of debt and theamortization of expenses related to intangible assets. In addition,acquisitions involve numerous risks, including difficulties in the assimilationof operations, technologies, products and personnel of the acquired company,diversion of management’s attention from other business concerns, risks ofentering markets in which we have no direct or limited prior experience, thepotential loss of key employees of the acquired company, unanticipated costsand, in the case of the acquisition of financially troubled businesses,challenges as to the validity of such acquisitions from third party creditorsof such businesses. For example, in the fourth quarter 2004, we encountereddifficulties in integrating HSI’s legacy operations into our operations anddetermined to abandon a substantial amount of HSI’s legacy operations. As aresult, in the fourth quarter 2004, we wrote off the entire goodwill andintangibles associated with HSI. In addition, the acquisitions of businessesinvolved in the manufacturing or sales of handset products could introducespecific litigation risk from the potential harmful effects of electric andmagnetic fields (“EMF”).

 

*We may be unable to adequatelyprotect the loss or misappropriation of our intellectual property, which couldsubstantially harm our business.*

 

Werely on a combination of patents, copyrights, trademarks, trade secret laws andcontractual obligations to protect our technology. We have applied for patentsin the United States and internationally. Additional patents may not be issuedfrom our pending patent applications, and our issued patents may not be upheld.In addition, we have, from time to time, chosen to abandon previously filedapplications. Moreover, we may face difficulties in registering our existingtrademarks in new jurisdictions in which we operate. We cannot guarantee thatthe intellectual property protection measures that we have taken will besufficient to prevent misappropriation of our technology or trademarks or thatour competitors will not independently develop technologies that aresubstantially equivalent or superior to ours. In addition, the legal systems ofmany foreign countries do not protect or honor intellectual property rights tothe same extent as the legal system of the United States. For example, inChina, the legal system in general, and the intellectual property regime inparticular, are still in the development stage. It may be very difficult,time-consuming and costly for us to attempt to enforce our intellectualproperty rights in these jurisdictions.

 

*We may be subject to claims thatwe infringe the intellectual property rights of others, which couldsubstantially harm our business.*

 

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Theindustry in which we compete is moving towards aggressive assertion, licensing,and litigation of patents and other intellectual property rights. From time totime, we have become aware of the possibility or have been notified that we maybe infringing certain patents or other intellectual property rights of others.Regardless of their merit, responding to such claims could be time consuming,divert management’s attention and resources and cause us to incur significantexpenses. In addition, although some of our supplier contracts provide forindemnification from the supplier with respect to losses or expenses incurredin connection with any infringement claim, certain contracts with our keysuppliers do not provide for such protection. Moreover, certain of our salescontracts provide that we must indemnify our customers against claims by thirdparties for intellectual property rights infringement related to our products.There are no limitations on the maximum potential future payments under theseguarantees. Therefore, we may incur substantial costs related to anyinfringement claim, which may substantially harm our results of operations andfinancial condition.

 

Wemay, in the future, become subject to litigation to defend against claimedinfringements of the rights of others or to determine the scope and validity ofthe proprietary rights of others. Future litigation may also be necessary toenforce and protect our trade secrets and other intellectual property rights.Any intellectual property litigation or threatened intellectual propertylitigation could be costly, and adverse determinations or settlements could resultin the loss of our proprietary rights, subject us to significant liabilities,require us to seek licenses from or pay royalties to third parties which maynot be available on commercially reasonable terms, if at all, and/or prevent usfrom manufacturing or selling our products, which could cause disruptions toour operations.

 

In the event thatthere is a successful claim of infringement against us and we fail to developnon-infringing technology or license the propriety rights on commerciallyreasonable terms and conditions, our business, results of operations orfinancial condition could be materially and adversely impacted.

 

*Our multinational operations subject us to variouseconomic, political, regulatory and legal risks.*

* *

Wemarket and sell our products globally, historically, with the majority of oursales made in China. The expansion of our existing multinational operations andentry into new markets will require significant management attention andfinancial resources. Multinational operations are subject to a variety ofrisks, such as:

 

•                                          the burden of complying with a variety offoreign laws and regulations;

 

•                                          the burden of complying with United Stateslaws and regulations for foreign operations, including the Foreign   Corrupt Practices Act;

 

•                                          difficulty complying with continuallyevolving and changing global product and communications standards andregulations for both our end products and their component technology;

 

•                                          market acceptance of our new products,including longer product acceptance periods in new markets into which we enter;

 

•                                          reliance on local original equipmentmanufacturers (“OEMs”), third party distributors and agents to effectivelymarket and sell our products;

 

•                                          unusual contract terms required by customersin developing markets;

 

•                                          changes in local governmental control orinfluence over our customers;

 

•                                          changes to import and export regulations,including quotas, tariffs, licensing restrictions and other trade barriers;

 

•                                          evolving and unpredictable nature of theeconomic, regulatory, competitive and political environments;

 

•                                          reduced protection for intellectual propertyrights in some countries;

 

•                                          longer accounts receivable collectionperiods; and

 

•                                          difficulties and costs of staffing andmanaging multinational operations, including but not limited to internalcontrols and compliance.

 

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*We do business in markets that are not fullydeveloped, which subjects us to various economic, political, regulatory andlegal risks unique to developing economies.*

* *

Lessdeveloped markets present additional risks, such as the following:

 

•                                          customers that may be unable to pay for ourproducts in a timely manner or at all;

 

•                                          new and unproven markets for our products andthe telecommunications services that our products enable;

 

•                                          inconsistent infrastructure support;

 

•                                          lack of a large, highly trained workforce;

 

•                                          difficulty in controlling local operationsfrom our headquarters;

 

•                                          variable ethical standards and an increasedpotential for fraud;

 

•                                          unstable political and economic environments;and

 

•                                          a lack of a secure environment for ourpersonnel, facilities and equipment.

 

Inparticular, these factors create the potential for physical loss of inventoryand operating assets. We have in the past experienced cases of vandalism andarmed theft of our equipment that had been or was being installed in the field.If disruptions for any of these reasons become too severe in any particularmarket, it may become necessary for us to terminate contracts and withdraw fromthat market and suffer the associated costs and lost revenue.

 

*We are subject to claims of possible health risksfrom wireless handsets.*

* *

Therehave been claims made alleging a link between the use of wireless handsets andthe development or aggravation of certain cancers, including brain cancer. Thescientific community is divided on whether there is a risk from wirelesshandset use, and if so, the magnitude of the risk. Even if there is no linkestablished between wireless handset use and cancer, the negative publicity andpossible litigation could have a material adverse effect on our business.

 

Inthe past, several plaintiffs’ groups have brought class actions againstwireless handset manufacturers and distributors, alleging that wirelesshandsets have caused cancer. To date, we have not been named in any of theseactions and none of these actions has been successful. In the future we couldincur substantial costs in defending ourselves against similar claims,regardless of their merit. Also, claims may be successful in the future andhave a material adverse effect on our business.

 

*We are subject to risks relating to currency ratefluctuations and exchange controls.*

* *

Becausemost of our sales are made in foreign countries, we are exposed to market riskfor changes in foreign exchange rates on our foreign currency denominatedaccounts and notes receivable balances. Historically, the majority of our saleshave been made in China and denominated in Renminbi; as such, the impact ofcurrency fluctuations of Renminbi thus far has been insignificant as it isfixed to the U.S. dollar.  However, as wework to expand our international sales, we may become increasingly subject toforeign exchange risk.

 

However,in the future, China could choose to revalue the Renminbi versus the U.S.dollar, or the Renminbi-U.S. dollar exchange rate could float, and the Renminbicould depreciate relative to the U.S. dollar. Additionally, we have experiencedincreases in sales in both Japanese Yen and in Euros. Fluctuations in currencyexchange rates in the future may have a material adverse effect on our resultsof operations.

 

Weenter into transactions that may expose us to foreign currency rate fluctuationrisk. Historically, the largest component of our foreign currency exchange losshas resulted from our purchasing inventory denominated in foreign currencies.If we continue to purchase inventory in foreign currencies, we may incuradditional foreign currency exchange losses, causing our operating results tosuffer.

 

Wemay, from time to time, enter into foreign exchange forward contracts to hedgecertain translation exposures, due to fluctuation of the U.S. dollar to theJapanese Yen, resulting from Japanese Yen-dominated balance sheet accounts.However, our management has 

 

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hadlimited prior experience in engaging in these types of transactions, and thehedging may not be effective in limiting our exposure to a decline in operatingresults.

 

Moreover,some of the foreign countries in which we do business might impose currencyrestriction that may limit the ability of our subsidiaries and joint venturesin such countries to obtain and remit foreign currency necessary for thepurchase of imported components and may limit our ability to obtain and remitforeign currency in exchange for foreign earnings. For example, China employscurrency controls restricting Renminbi conversion, limiting our ability toengage in currency hedging activities in China. Various foreign exchangecontrols may also make it difficult for us to repatriate earnings, which couldhave a material adverse effect on our ability to conduct business globally.

 

*Business interruptions could adversely affect ourbusiness.*

* *

Ouroperations are vulnerable to interruption by fire, earthquake, power loss,telecommunications failure, external interference with our informationtechnology systems, incidents of terrorism and other events beyond our control.For example, our Hangzhou manufacturing facility’s ability to producesufficient products is dependent upon a continuous power supply. However, theHangzhou facility has in the past been subject to power shortages, which hasaffected our ability to produce and ship sufficient products. We do not have adetailed disaster recovery plan, and the occurrence of any events like thesethat disrupt our business could harm our operating results.

 

*We may suffer losses with respect to equipment heldat customer sites, which could harm our business.*

* *

Weface the risk of loss relating to our equipment held at customer sites. In somecases, our equipment held at customer sites is under contract, pending finalacceptance by the customer. We generally do not hold title or risk of loss onsuch equipment, as title and risk of loss are typically transferred to thecustomer upon delivery of our equipment. However, we do not recognize revenueand accounts receivable with respect to the sale of such equipment until weobtain acceptance from the customer. If we do not obtain final acceptance, wemay not be able to collect the contract price and recover this equipment or itsassociated costs. In other cases, particularly in China, where governmentalapproval is required to finalize certain contracts, inventory not undercontract may be held at customer sites. We hold title and risk of loss on thisinventory until the contracts are finalized and, as such, are subject to anylosses incurred resulting from any damage to or loss of this inventory. If ourcontract negotiations fail or if the government of China otherwise delaysapproving contracts, we may not recover or receive payment for this inventory.Moreover, our insurance may not cover all losses incurred if our inventory atcustomer sites not under contracts is damaged prior to contract finalization.If we incur a loss relating to inventory for any of the above reasons, ourfinancial condition, cash flows, and operating results could be harmed.

 

*We have been named as a defendant in securitieslitigation and other lawsuits, as well as lawsuits in the ordinary course ofbusiness.*

* *

Weare currently a defendant in several securities litigation class actions andother lawsuits, as well as lawsuits in the ordinary course of our business. Inthe future, we may be subject to similar litigation. The defense of theselawsuits may divert our management’s attention, and we may incur significantexpenses in defending these lawsuits (including substantial fees of lawyers andother professional advisors and potential obligations to indemnify officers anddirectors who may be parties to such actions). In addition, we may be requiredto pay judgments or settlements that could have a material adverse effect onour results of operations, financial condition and liquidity.

 

*Restrictions on the use of handsets while drivingcould affect our future growth.*

* *

Severalforeign governments and U.S. state and local governments have adopted or areconsidering adopting legislation that would restrict or prohibit the use ofwireless handsets while driving. Widespread legislation that restricts orprohibits the use of wireless handsets while driving could negatively affectour future growth.

 

*F**ailureto achieve and maintain effective internal controls in accordance with Section404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect onour business and stock price.*

 

Section404 of the Sarbanes-Oxley Act of 2002 (“the Sarbanes-Oxley Act”) requires thatwe establish and maintain an adequate internal control structure and proceduresfor financial reporting and include a report of management on our internalcontrol over financial reporting in our annual report on Form 10-K. That reportmust contain an assessment by management of the effectiveness of our internalcontrol over financial reporting and must include disclosure of any materialweaknesses in internal control over financial 

 

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reportingthat we have identified. In addition, our independent registered publicaccounting firm must attest to and report on management’s assessment of theeffectiveness of our internal control over financial reporting.

 

Wehave identified material weaknesses in our internal controls over financialreporting. See “Item 9A—Controls and Procedures—Management’s Report on InternalControl Over Financial Reporting” in our Annual report on Form 10-K for adiscussion of these material weaknesses. As of the date of the filing of this quarterlyreport on Form 10-Q, we are still in the process of implementing remedialmeasures related to the material weaknesses identified. If our efforts toremedy the weaknesses we identified are not successful, our business andoperating results could be harmed and the reliability of our financialstatements could be impaired, which could adversely affect our stock price. Therequirements of Section 404 of the Sarbanes-Oxley Act are ongoing and alsoapply to future years. In addition, during 2005, we will apply the requirementsof the Sarbanes-Oxley Act to our November 2004 acquisition of ACC, which wasexempted from our 2004 assessment as permitted under the Sarbanes-Oxley Act. Weexpect that our internal controls over financial reporting will continue toevolve as we continue in our efforts to grow and expand our business in thefuture. Although we are committed to continue to improve our internal controlprocesses and we will continue to diligently and vigorously review our internalcontrols over financial reporting in order to ensure compliance with theSection 404 requirements, any control system, regardless of how well designed,operated and evaluated, can provide only reasonable, not absolute, assurancethat its objectives will be met. Therefore, we cannot assure you that in thefuture additional material weaknesses or significant deficiencies will not existor otherwise be discovered.

 

*Recently enacted and proposed changes in securitieslaws and regulations are likely to increase our costs.*

* *

TheSarbanes-Oxley Act has required and will continue to require changes in some ofour corporate governance and securities disclosure or compliance practices. TheSarbanes-Oxley Act also requires the SEC to promulgate new rules on a varietyof subjects, in addition to rule proposals already made, and NASDAQ has revisedits requirements for companies that are quoted on it. These developments (i)have required and may continue to require us to devote additional resources toour operational, financial and management information systems procedures andcontrols to ensure our continued compliance with current and future laws andregulations, (ii) will make it more difficult and more expensive for us toobtain director and officer liability insurance, and we may be required toaccept reduced coverage, increase our level of self-insurance, or incursubstantially higher costs to obtain coverage, and (iii) could make it moredifficult for us to attract and retain qualified members on our board ofdirectors, or qualified executive officers. To implement plans and measures tocomply with Section 404 of the Sarbanes-Oxley Act and other related rules, weincurred costs of approximately $7.2 million through March 31, 2005.  We continue to evaluate and monitor regulatorydevelopments and cannot estimate the timing or magnitude of additional coststhat we may incur as a result of such developments.

 

*Changes in accounting rules.*

* *

Weprepare our financial statements in conformity with accounting principlesgenerally accepted in the United States of America. These principles aresubject to interpretation by the SEC and various bodies formed to interpret andcreate appropriate accounting policies. A change in these policies can have asignificant effect on our reported results and may even retroactively affectpreviously reported transactions. For example, there have been recent changesto FASB guidelines relating to accounting for stock-based compensation thatwill increase our compensation expense, could make our net income lesspredictable in any given reporting period and could change the way wecompensate our employees or cause other changes in the way we conduct ourbusiness.

 

# **RISKSRELATED TO CONDUCTING BUSINESS IN CHINA**

# ** **

*China’s governmental and regulatory reforms mayimpact our ability to do business in China.*

* *

Since1978, the Chinese government has been in a state of evolution and reform. Thereforms have resulted in and are expected to continue to result in significanteconomic and social development in China. Many of the reforms are unprecedentedor experimental and may be subject to change or readjustment due to a varietyof political, economic and social factors. Multiple government bodies areinvolved in regulating and administrating affairs in the telecommunicationsindustry, among which the MII, the National Development and Reform Commission (“NDRC”)and the State Asset Supervisory Administrative Commission (“SASAC”) play theleading roles. These government agencies have broad discretion and authorityover all aspects of the telecommunications and information technology industryin China, including but not limited to, setting the telecommunications tariffstructure, granting carrier licenses and frequencies, approving equipment andproducts, granting product licenses, specifying technological standards as wellas appointing carrier executives, all of which may impact our ability to dobusiness in China.

 

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Whilewe anticipate that the basic principles underlying the reforms will remainunchanged, any of the following changes in China’s political and economicconditions and governmental policies could have a substantial impact on ourbusiness:

 

•                                          the promulgation of new laws and regulationsand the interpretation of those laws and regulations;

 

•                                          inconsistent enforcement and application ofthe telecommunications industry’s rules and regulations by the Chinesegovernment between foreign and domestic companies;

 

•                                          the restructuring of telecommunicationscarriers in China;

 

•                                          the introduction of measures to controlinflation or stimulate growth;

 

•                                          the introduction of new guidelines fortariffs and service rates, which affect our ability to competitively price ourproducts and services;

 

•                                          changes in the rate or method of taxation;

 

•                                          the imposition of additional restrictions oncurrency conversion and remittances abroad; or

 

•                                          any actions that limit our ability todevelop, manufacture, import or sell our products in China, or to finance andoperate our business in China.

 

Forexample, on November 1, 2004, as a continuation of the restructuring oftelecom carriers relating to the initial public offering of China Netcom in2004, SASAC decided to swap the senior executives of China Mobile, ChinaUnicom, China Telecom and China Netcom in an effort to ease competition amongcarriers. This led to business interruption between China Telecom and ChinaNetcom, which had an adverse impact of delaying revenue recognition in thefourth quarter of 2004. Moreover, we are not certain whether there may beadditional government interference, including government imposed mergers orspin-offs of the existing carriers.

 

Inaddition to modifying the existing telecommunications regulatory framework, theChinese government is currently preparing a draft of a standard, nationaltelecommunications law (the “Telecommunications Law”) to provide a uniformregulatory framework for the telecommunications industry. We do not yet knowthe final nature or scope of the regulations that would be created if theTelecommunications Law is passed. Accordingly, we cannot predict whether itwill have a positive or negative effect on us or on some or all aspects of ourbusiness.

 

Under China’scurrent regulatory structure, the communications products that we offer inChina must meet government and industry standards. In addition, a networkaccess license for the equipment must be obtained. Without a license,telecommunications equipment is not allowed to be connected to publictelecommunications networks or sold in China. Moreover, we must ensure that thequality of the telecommunications equipment for which we have obtained anetwork access license is stable and reliable, and will not negatively affectthe quality or performance of other installed licensed products.

 

Theproduct quality supervision department of the China State Council, in concertwith the MII, performs spot checks to track and supervise the quality oflicensed telecommunications equipment and publishes the results of such spotchecks.

 

*China’s changing economic environment may impact ourability to do business in China.*

* *

Since1978, the Chinese government has been reforming the economic system in China toincrease the emphasis placed on decentralization and the utilization of marketforces in the development of China’s economy. These reforms have resulted insignificant economic growth. However, any economic reform policies or measuresin China may from time to time be modified or revised by the Chinesegovernment. While we may be able to benefit from the effects of some of thesepolicies, these policies and other measures taken by the Chinese government toregulate the economy could also have a significant negative impact on economicconditions in China, which would result in a negative impact on our business.China’s economic environment has been changing as a result of China’s entry, inDecember of 2001, into the World Trade Organization (the “WTO”). Entryinto the WTO requires that China reduce tariffs and eliminate non-tariffbarriers, including quotas, licenses and other restrictions by early 2005 atthe latest and we cannot predict the impact of these changes on China’seconomy. Moreover, although China’s entry into the WTO and the related relaxationof trade restrictions may lead to increased foreign investment, it may alsolead to increased competition in China’s markets 

 

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fromother foreign companies. If China’s entry into the WTO results in increasedcompetition or has a negative impact on China’s economy, our business couldsuffer. In addition, although China is increasingly according foreign companiesand foreign investment enterprises established in China the same rights andprivileges as Chinese domestic companies as a result of its admission into theWTO, special laws, administrative rules and regulations governing foreigncompanies and foreign investment enterprises in China may still place foreigncompanies at a disadvantage in relation to Chinese domestic companies and mayadversely affect our competitive position.

 

*Uncertainties with respect to the Chinese legalsystem may adversely affect us.*

* *

Weconduct our business in China primarily through our wholly owned subsidiariesincorporated in China. Our subsidiaries are generally subject to laws andregulations applicable to foreign investment in China. Accordingly, ourbusiness might be affected by China’s developing legal system. Since 1978, manynew laws and regulations covering general economic matters have beenpromulgated in China, and government policies and internal rules promulgatedby governmental agencies may not be published in time, or at all. As a result,we may operate our business in violation of new rules and policies withouthaving any knowledge of their existence. In addition, there are uncertaintiesregarding the interpretation and enforcement of laws, rules and policiesin China. The Chinese legal system is based on written statutes, and priorcourt decisions have limited precedential value. Because many laws andregulations are relatively new and the Chinese legal system is still evolving,the interpretations of many laws, regulations and rules are not alwaysuniform. Moreover, the relative inexperience of China’s judiciary in many casescreates additional uncertainty as to the outcome of any litigation, and theinterpretation of statutes and regulations may be subject to governmentpolicies reflecting domestic political changes. Finally, enforcement ofexisting laws or contracts based on existing law may be uncertain and sporadic,and it may be difficult to obtain swift and equitable enforcement, or to obtainenforcement of a judgment by a court of another jurisdiction. Any litigation inChina may be protracted and result in substantial costs and diversion ofresources and management’s attention.

 

*If tax benefits available to our subsidiarieslocated in China are reduced or repealed, our business could suffer.*

* *

The Chinesegovernment is considering the imposition of a “unified” corporate income taxthat would phase out, over time, the preferential tax treatment to whichforeign investment enterprises, such as our Company, are currently entitled.While it is not certain whether the government will implement such a unifiedtax structure or whether we will be grandfathered under into any new taxstructure, if a new tax structure is implemented, a new tax structure mayadversely affect our financial condition. Moreover, certain of our subsidiariesand joint ventures located in China enjoy tax benefits in China that aregenerally available to foreign investment enterprises. If these tax benefitsare reduced or repealed due to changes in tax laws, our business could suffer.

 

*Our ability to continue successful deployment of PASsystem and sales of PAS handsets are limited by certain factors, including thefollowing:*

* *

*Maturing PAS market and increased competition inhandsets and tariffs.*

* *

Themarket for PAS exceeded 66 million users as of the end of fiscal year 2004 andis present throughout China. As the PAS market has matured, we believe that itmay level off in the near future. For example, during the first quarter 2005,net sales of the PAS/IPAS system and the wireless infrastructure marketsignificantly declined.  In addition, theincrease in handset competitors entering the market during 2004 has resulted indecreased average selling prices and margins. * *If additional handset competitorsenter the market or if competitors decide to further reduce pricing, our salesof PAS handsets may be adversely impacted.

 

Furthermore,competition from mobile operators, such as China Mobile and China Unicom, hasincreased in cities where PAS is deployed. Mobile operators offering specialpromotional pricing or incentives to customers, such as free incoming calls orfree mobile-to-mobile calls, have harmed the ability of our customers, ChinaTelecom and China Netcom, to compete effectively. The continued use of suchincentive programs by mobile operators may adversely impact China Telecom andChina Netcom’s ability to increase PAS subscriptions. Due to our relationshipswith China Telecom and China Netcom, reduced subscription growth at thesecarriers may have a material adverse effect on our pricing and harm ourbusiness or results of operations.

 

*Our PAS system and handsets sales may experience asharp decline if China Telecom or China Netcom obtain licenses allowing them todeliver mobile services.*

* *

China’smedia sources have widely reported that the MII may grant 3G mobile licenses toChina Telecom or China Netcom, or to both during 2005. If China Telecom orChina Netcom obtain 3G mobile licenses, they may re-allocate capitalexpenditures to construct 3G 

 

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networks,and as a consequence, may significantly reduce capital expenditures relating toPAS networks that utilize our existing products. In addition, it is possiblethat current PAS frequency bands utilized by PAS networks may be reallocatedfor use by 3G networks, resulting in the restriction of or shutting down of PASnetworks. If this were to occur, we could lose current and potential futurecustomers of our products, and our financial condition and results ofoperations could be significantly harmed.

 

*We only have trial licenses for the PAS system andhandsets in China.*

* *

Weonly have trial licenses for our PAS systems and handsets. We have applied for,but have not yet received, a final official network access license for our PASsystems and handsets. Based upon conversations with the MII, we understand thatour PAS systems and handsets are considered to still be in the trial period andthat sales of our PAS systems and handsets may continue to be made by us duringthis trial period, but that licenses will ultimately be required. If we fail toobtain the required licenses, we could be prohibited from making further salesof the unlicensed products, including our PAS systems and handsets, in China,which would substantially harm our business, financial condition and results ofoperations. The regulations implementing these requirements are not verydetailed, have not been applied by a court and may be interpreted and enforcedby regulatory authorities in a number of different ways. Our legal counsel inChina has advised us that China’s governmental authorities may interpret orapply the regulations with respect to which licenses are required and theability to sell a product while a product is in the trial period in a mannerthat is inconsistent with the information received by our legal counsel inChina, and either of these conditions could have a material adverse effect onour business, financial condition and results of operations.

 

*Increasing centralization of purchasingdecision-making by carriers may lead to customer concentration and affect theresults of our business.*

* *

MostChinese carriers have three levels of operations; the central headquarterslevel, the provincial level and the local city/county level. Both central andprovincial levels are independent legal persons and have their own corporatemandate. The purchasing decision making process may take various forms fordifferent projects and may also differ significantly from carrier to carrier.

 

Inthe case of PAS systems, all China Netcom contracts are negotiated and enteredinto between the provincial operators and the Company. However, the centralheadquarters of China Telecom recently began exerting more influence in thepurchasing decision-making process by negotiating contractual terms, such aspurchase price, payment terms, and acceptance clauses at the central level. Theprovincial operator then further negotiates the contract based on theguidelines provided by the headquarters. Final contracts are entered intobetween the provincial operator and the Company. However, if this trend ofcentralized decision-making expands to unified purchasing, resulting in thenegotiation and execution of contracts at the central headquarter level, theremay be a concentration of customers which could have a significant impact onour business.

 

RISKS RELATED TO OUR STOCK PERFORMANCE AND CONVERTIBLEDEBT SECURITIES

 

*Our stock price is highly volatile.*

* *

Thetrading price of our common stock has fluctuated significantly since ourinitial public offering in March of 2000. Our stock price could be subjectto wide fluctuations in the future in response to many events or factors,including those discussed in the preceding risk factors relating to ouroperations, as well as:

 

•                                          actual or anticipated fluctuations inoperating results, actual or anticipated gross profit as a percentage of netsales, levels of inventory, our actual or anticipated rate of growth and ouractual or anticipated earnings per share;

 

•                                          changes in expectations as to futurefinancial performance or changes in financial estimates or buy/sellrecommendations of securities analysts;

 

•                                          changes in governmental regulations orpolicies in China;

 

•                                          our, or a competitor’s, announcement of newproducts, services or technological innovations;

 

•                                          the operating and stock price performance ofother comparable companies; and

 

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•                                          news and commentary emanating from the media,securities analysts or government bodies in China relating to us and to theindustry in general.

 

Generalmarket conditions and domestic or international macroeconomic factors unrelatedto our performance may also affect our stock price. For these reasons,investors should not rely on recent trends to predict future stock prices orfinancial results. In addition, following periods of volatility in a company’ssecurities, securities class action litigation against a company is sometimesinstituted. This type of litigation could result in substantial costs and thediversion of management’s time and resources.

 

Inaddition, public announcements by China Telecom, China Netcom, China Mobile,and China Unicom each of which exert significant influence over many of ourmajor customers in China, may contribute to volatility in the price of ourstock. The price of our stock may react to such announcements.

 

*SOFTBANK CORP. and its related entities, includingSOFTBANK America Inc., have significant influence over our management andaffairs, which it could exercise against the best interests of ourstockholders.*

* *

SOFTBANKCORP. and its related entities, including SOFTBANK America Inc. (collectively, “SOFTBANK”),beneficially owned approximately 12.8% of our outstanding stock as of March 31,2005. As a result, SOFTBANK has the ability to influence all matters submittedto our stockholders for approval, as well as our management and affairs.Matters that could require stockholder approval include:

 

•                                          election and removal of directors;

 

•                                          merger or consolidation of our Company; and

 

•                                          sale of all or substantially all of ourassets.

 

Thisconcentration of ownership may delay or prevent a change of control ordiscourage a potential acquirer from making a tender offer or otherwiseattempting to obtain control of our Company, which could decrease the marketprice of our common stock.

 

*Delaware law and our charter documents containprovisions that could discourage or prevent a potential takeover, even if thetransaction would benefit our stockholders.*

* *

Othercompanies may seek to acquire or merge with us. An acquisition or merger of ourCompany could result in benefits to our stockholders, including an increase inthe value of our common stock. Some provisions of our Certificate ofIncorporation and Bylaws, as well as provisions of Delaware law, maydiscourage, delay or prevent a merger or acquisition that a stockholder mayconsider favorable. These provisions include:

 

•                                          authorizing the board of directors to issueadditional preferred stock;

 

•                                          prohibiting cumulative voting in the electionof directors;

 

•                                          limiting the persons who may call specialmeetings of stockholders;

 

•                                          prohibiting stockholder action by writtenconsent;

 

•                                          creating a classified board of directorspursuant to which our directors are elected for staggered three year terms; and

 

•                                          establishing advance notice requirements fornominations for election to the board of directors and for proposing mattersthat can be acted on by stockholders at stockholder meetings.

 

*Together with the holders of our convertiblesubordinated notes due in 2008, we face a variety of risks related to thenotes.*

* *

Holdersof our convertible subordinated notes due in 2008 (the “Notes”) and we face avariety of risks with respect to the Notes, including the following:

 

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•                                          we may be limited in our ability to purchasethe Notes in the event of a change in control, either for cash or stock, whichcould result in our defaulting on the Notes at the time of the change incontrol and purchases for stock would be subject to market risk;

 

•                                          an event of default under our senior debt,including one of our subsidiaries, could restrict our ability to purchase orpay any or all amounts due on Notes, and after paying our senior debt in full,we may not have sufficient assets remaining to pay any or all amounts due onthe Notes;

 

•                                          there is no listed trading market for theNotes, which could have a negative impact on the market price of the Notes;

 

•                                          we have significantly increased our leverageas a result of the sale of the Notes which could have an adverse impact on ourability to obtain additional financing for working capital;

 

•                                          hedging transactions related to the Notes andour common stock and other transactions, as well as changes in interest ratesand our creditworthiness, may affect the value of the Notes and of our commonstock; and

 

•                                          the Notes might not be rated or may receive alower rating than anticipated by investors, ultimately having a negative affecton the price of the Notes and of our common stock.

 

In addition, weare subject to various covenants and obligations pursuant to the terms of theindenture governing the Notes (the “Indenture”). Should we default on certainof these obligations, then all unpaid principal and accrued interest on theNotes then outstanding could become immediately due and payable. For example, fromApril 1, 2005 to April 15, 2005, we were in technical noncomplianceunder the Indenture due to the untimely filing of our Annual Report on Form 10-Kfor the year ended December 31, 2004 (the “Annual Report”). If in thefuture we fail to file all reports and other information and documents which weare required to file with the SEC pursuant to Section 13 or 15(d) andwe fail to cure such technical non compliance within 60 days of written noticebeing provided to us by either the trustee under the Indenture or the holdersof at least 25% in aggregate principal amount of the Notes then outstanding, anevent of default under the Indenture will be deemed to occur. If an event ofdefault under the Indenture occurs and if payment of principal and accruedinterest on the Notes is accelerated, our business could be seriously harmed.

 

**ITEM 3****—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISKS**

 

We are exposed to the impactof interest rate changes, changes in foreign currency exchange rates and changesin the stock market.

 

*InterestRate Risk.*  Ourexposure to market risk for changes in interest rates relates primarily to ourinvestment portfolio. The fairvalue of our investment portfolio would not be significantly affected by eithera 10% increase or decrease in interest rates due mainly to the short-termnature of most of our investment portfolio. However, our interest income can besensitive to changes in the general level of U.S. interest rates since themajority of our funds are invested in instruments with maturities less than oneyear. Our policy is to ensure the safety of invested funds by generallyattempting to limit market risk. Funds in excess of current operatingrequirements are mostly invested in government-backed notes, commercial paper,floating rate corporate bonds, fixed income corporate bonds and tax-exemptinstruments. In accordance with our investment policy, all short-terminvestments are invested in “investment grade” rated securities with minimum Aor better ratings. Currently, most of our short-term investments have AA orbetter ratings.

 

The table below representscarrying amounts and related weighted-average interest rates of our investmentportfolio at March 31, 2005:

 

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| **(in thousands, except interest rates)** | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|------------|------------|
| Cash and cash equivalents                 |       | $          | 372,714    |   |
| Average interest rate                     |       | 0.99       | %          |
|                                      |       |       |       |
| Restricted cash                           |       | 21,282     |       |
| Average interest rate                     |       | 1.84       | %          |
|                                      |       |       |       |
| Restricted short-term investments         |       | 8,269      |       |
| Average interest rate                     |       | 3.10       | %          |
|                                      |       |       |       |
| Short-term investments                    |       | 16,224     |       |
| Average interest rate                     |       | 2.16       | %          |
|                                      |       |       |       |
| Long-term investments                     |       | 2,581      |       |
| Average interest rate                     |       | 2.00       | %          |
|                                      |       |       |       |
| Total investment securities               |       | $          | 421,070    |   |
| Average interest rate                     |       | 1.12       | %          |

 

*Foreign ExchangeRate Risk.*  Weare exposed to foreign currency exchange rate risk because most of our sales inChina are denominated in Renminbi. Due to the limitations on convertingRenminbi, we are limited in our ability to engage in foreign currency hedgingactivities in China.  Beginning in the first quarter of 2004, we hedgecertain Japanese Yen-denominated balance sheet exposures against futuremovements in foreign currency exchange rates by using foreign currency forwardcontracts. Gains and losses on these fair value hedges are intended to offsetgains and losses from the revaluation of our Japanese Yen-denominatedrecognized liabilities. In accordance with Statement of Financial AccountingStandards No. 133 (“SFAS 133”), “Accounting for Derivative Instruments andHedging Activities,” we recognize derivative instruments and hedging activitiesas either assets or liabilities on the balance sheet and measure them at fairvalue. The net result of gains and losses on contracts and revaluation includedin interest and other income (expense) was insignificant for the three monthsended March 31, 2005. Our foreign currency forward contracts generallymature within three months. We do not intend to utilize derivative financialinstruments for speculative trading purposes. There were no foreign currency forward contracts held at March 31,2005. Movements in currency exchange rates could cause variability in our otherincome (expense).

 

Although the impact ofcurrency fluctuations of Renminbi to date has been insignificant, fluctuationsin foreign currency exchange rates in the future may have a material adverseeffect on our results of operations. We maintain a bank account in Japanese Yenfor purchasing portions of our inventories and supplies.  The balance of this Japanese Yen account as ofMarch 31, 2005 was approximately $97.1 million.   Accounts Receivable balance andInter-company Accounts Receivable balance denominated in Japanese Yen as of March 31,2005 was $159.6 million and $13.5 million, respectively.  Due to the weakened Japanese Yen against theUS dollar recently, UTStarcom Inc. has incurred a total unrealized foreignexchange loss of $9.8 million, of which $3.4 million is due to Yen accountbalance, $4.9 million is due to Accounts Receivables denominated in JapaneseYen and $1.5 million is due to Inter-company Accounts Receivables.

 

#### **ITEM 4****—CONTROLS AND PROCEDURES**

####  

# **Evaluationof Disclosure Controls and Procedures**

# ** **

UTStarcom, Inc.(the “Company”) maintains disclosure controls and procedures that are designedto ensure that information required to be disclosed in the reports the Companyfiles or submits under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms, andthat such information is accumulated and communicated to the Company’smanagement, including its Chief Executive Officer (“CEO”) and Chief FinancialOfficer (“CFO”), as appropriate, to allow timely decisions regarding requireddisclosure.

 

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Inconnection with the preparation of this Quarterly Report on Form 10-Q,the Company carried out an evaluation under the supervision and with theparticipation of the Company’s management, including the CEO and CFO, as of March 31,2005 of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures, as such term is defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act. Based upon this evaluation, theCEO and CFO concluded that as of March 31, 2005 the Company’s disclosurecontrols and procedures were not effective because of the material weaknessesdescribed under “Management’s Report on Internal Control Over FinancialReporting” in Item 9A of the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004 (the “2004 Form 10-K”),which the Company is still in the process of remediating. Investors aredirected to Item 9A of the 2004 Form 10-K for the description ofthese weaknesses.

 

Toaddress the material weaknesses described in “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2004 Form 10-K,the Company performed additional analyses and other procedures (as furtherdescribed below under the subheadings “Interim Measures” under “Management’sRemediation Initiatives and Interim Measures”) to ensure that the Company’sconsolidated financial statements included in this Quarterly Report on Form 10-Qwere prepared in accordance with accounting principles generally accepted inthe United States.  Accordingly, theCompany’s management believes that the consolidated financial statementsincluded in this Quarterly Report on Form 10-Q fairly present in allmaterial respects the Company’s financial condition, results of operations andcash flows for the periods presented and that this Quarterly Report on Form 10-Qdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of the circumstancesunder which such statements were made, not misleading with respect to theperiod covered by this report.

 

**Management’s Remediation Initiatives and Interim Measures**

 

Inresponse to the matters discussed in “Management’s Report on Internal ControlOver Financial Reporting” in Item 9A of the 2004 Form 10-K, theCompany plans to continue to review and make necessary changes to the overalldesign of its control environment, including the roles and responsibilities ofeach functional group within the organization and reporting structure, as wellas policies and procedures to improve the overall internal control overfinancial reporting. In particular, the Company has implemented and/or plans toimplement during 2005 the specific measures described below to remediate thematerial weaknesses described in “Management’s Report on Internal Control OverFinancial Reporting” in Item 9A of the 2004 Form 10-K.  In addition, in the absence of fullimplementation of these remediation measures as of March 31, 2005, during thefirst quarter of 2005 or subsequent to March 31, 2005 in connection withthe March 31, 2005 quarter-end reporting process, the Company hasundertaken the additional measures described under the subheadings “—InterimMeasures” below to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of the Company’s financial statementsincluded in this Quarterly Report on Form 10-Q and to ensure thatmaterial information relating to the Company and its consolidated subsidiarieswas made known to management in connection with the preparation of thisQuarterly Report on Form 10-Q. 

 

***Material weaknesses described in item 1 of “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

 

*Remediation Initiatives*.     TheCompany’s failure to have a sufficient complement of personnel with a level ofaccounting knowledge, experience and training in the application of generallyaccepted accounting principles commensurate with the Company’s financialreporting requirements contributed to the Company’s failure to maintaineffective controls over the financial reporting process. To remediate thematerial weaknesses described in item 1 of “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2004 Form 10-K,the Company has implemented or plans to implement the measures described below,and will continue to evaluate and may in the future implement additionalmeasures.

 

1.               General plan for hiring and training of personnel—TheCompany’s planned remediation measures are intended to generally address thismaterial weakness by ensuring that the Company will have sufficient personnelwith knowledge, experience and training in the application of generallyaccepted accounting principles commensurate with the Company’s financialreporting requirements. These measures include the following:

 

(a)          The Company’s chief financial officer, withassistance from senior financial staff and outside consultants, other than theCompany’s independent registered public accounting firm, has reviewed and willcontinue to review and adapt the 

 

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overalldesign of the Company’s financial reporting structure, including the roles andresponsibilities of each functional group within the Company;

 

(b)         The Company hired regional controllers withrelevant accounting experience, skills and knowledge for each of theAsia-Pacific region, the Central America and Latin America region, the Europe,Middle East and Africa region and Japan in late 2004 and early 2005;

 

(c)          The Company hired a consolidation manager inChina with relevant accounting experience, skills and knowledge in February 2005;

 

(d)         The Company hired a senior manager for SECreporting with relevant accounting experience, skills and knowledge in February 2005;

 

(e)          The Company promoted an individual within theCompany with relevant accounting experience, skills and knowledge to become thecontroller of China operations in April 2005;

 

(f)            The Company retained and intends to continueto retain the services of outside consultants, other than the Company’sindependent registered public accounting firm, with relevant accountingexperience, skills and knowledge, working under the supervision and directionof the Company’s management, to supplement the Company’s existing accountingpersonnel;

 

(g)   TheCompany hired a vice president of finance for the Company’s China operationswith relevant accounting experience, skills and knowledge in April 2005;

 

(h)         The Company plans to continue to hire, andhas allocated resources to hire, additional accounting personnel in the U.S.,China and Japan, in the areas of tax, external financial reporting, revenuerecognition, treasury, financial planning and analysis and corporate accountingwith relevant accounting experience, skills and knowledge; and

 

(i)             The Company in February 2005 implementedan enhanced formal training process for the training of financial staff andplans to continue this process to ensure that personnel have the necessarycompetency, training and supervision for their assigned level of responsibilityand the nature and complexity of the Company’s business.

 

2.               Revenue Recognition—The Company’s plannedremediation measures are intended to address material weaknesses related torevenue and deferred revenue accounts and associated cost of sales. Thesematerial weaknesses were evidenced by the identification of six separatetransactions aggregating approximately $5 million in which revenue was initiallyincluded in the Company’s fourth quarter 2004 financial statements before allcriteria for revenue recognition were met. In addition, there were othertransactions for which there was insufficient initial documentation for revenuerecognition purposes, but which did not result in any adjustments to theCompany’s fourth quarter 2004 financial statements. If unremediated, thesematerial weaknesses have the potential of misstating revenue in futurefinancial periods. The Company’s planned remediation measures include thefollowing:

 

(a)          The Company plans to design a contract reviewprocess in China requiring financial and legal staff to provide input duringthe contract negotiation process to ensure timely identification and accurateaccounting treatment of non-standard contracts;

 

(b)         In March 2005, the Company conducted atraining seminar regarding revenue recognition, including identification ofnon-standard contracts, in the U.S., and, in April 2005, the Companyconducted a similar seminar in China. Starting in May 2005, the Companyplans to conduct additional training seminars in various internationallocations regarding revenue recognition and the identification of non-standardcontracts; and

 

(c)          At the end of 2004, the Company beganrequiring centralized retention of documentation evidencing proof of deliveryand final acceptance for revenue recognition purposes.

 

3.               Inventory Management—The Company’s plannedremediation measures are intended to address material weaknesses related toinventory, deferred costs, inventory reserve accounts and cost of sales thathave the potential of misstating inventory and 

 

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deferred costs and expectedrecoverability of inventory in future financial periods. The Company’s plannedremediation measures include the following:

 

(a)          The Company is in the process of continuingto upgrade and implement additional Oracle modules to more effectively trackinventory and evaluate deferred costs;

 

(b)         The Company implemented in late 2004, andplans to improve during thesecond quarter of 2005, its process to confirm the existence ofoff-site inventory by systematically obtaining customer confirmations,investigating discrepancies in the confirmed results, and properly recordingand reporting the results of the investigation;

 

(c)          During the fourth quarter of 2004, theCompany initiated a process to accumulate information necessary to evaluateinventory and deferred cost contracts for impairment. The Company plans tocontinue to enhance this process in 2005 by better coordinating theaccumulation of such information from non-U.S. locations;

 

(d)         The Company plans to implement in 2005 morerobust controls over the release of costs to the income statement by betterutilizing the Oracle system;

 

(e)          The Company is in the process of selecting aservice provider with expertise and systems to more effectively manage andtrack the Company’s inventory in Japan, to whom the Company plans to outsourcethis function in 2005; and

 

(f)            The Company plans to deploy the Oracle systemin Japan by the third quarter of 2005.

 

4.               Accounting for Goodwill—The Company’s plannedremediation measures are intended to address a material weakness related to theCompany’s accounting for goodwill that has the potential of misstating goodwillamounts and the impairment of the Company’s goodwill in future financialperiods. The Company’s planned remediation measures include the following:

 

(a)          In the first quarter of 2005, the Companyimplemented a process of reallocating goodwill to the Company’s five reportingunits in a manner reflective of the Company’s new organization; and

 

(b)         As part of the process described in (a) above,the Company retained an outside consultant, working under the supervision anddirection of the Company’s management, to assist in a valuation analysis thatwas used in the allocation process. The Company plans to use the consultant onat least an annual basis to assist in a valuation and impairment analysis withrespect to goodwill.

 

5.               Foreign Exchange Translations—The Company’splanned remediation measures are intended to address a material weaknessrelated to the Company’s controls over its processes and procedures related tothe translation of its accounts and transactions denominated in a currencyother than U.S. dollars that has the potential of misstating various accountsin future financial periods. The Company’s remediation measures include theimplementation in the first quarter of 2005 of an enhanced foreign exchangeaccounting process utilizing the actual month-end exchange rates.

 

6.               Recording of Accrued Expenses and OpenPurchase Orders—The Company’s planned remediation measures are intended toaddress a material weakness related to the Company’s recording of accruedexpenses, primarily in China and Japan, that has the potential of misstatingaccrued expenses and related income statement accounts in future financialperiods. The Company’s planned remediation measures include the implementationin the first quarter of 2005 of a process of enhanced review of open purchaseorders and review of invoices and receipts after the end of each quarter toensure proper recording of accrued expenses and open purchase ordercommitments.

 

7.               Accurate Preparation and Review of FinancialStatements, Reconciliations, Journal Entries and Segment Reporting—The Company’splanned remediation measures are intended to address material weaknessesrelated to the financial close and reporting process that have the potential ofpreventing the accurate preparation and review of the Company’s consolidatedfinancial statements in future financial periods. The Company’s plannedremediation measures include the following:

 

(a)          During the first quarter of 2005, the Companybegan to implement, and plans to continue to improve, new and enhancedprocedures to ensure that non-routine transactions are identified and escalatedto senior financial management during the close process to help ensure properaccounting treatment. Specific steps include training and ongoing monitoring of

 

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financial staff, expansionof the officer sub-certifications and active review of contracts byknowledgeable financial and legal staff, from the contract negotiation processthrough recognition of revenue for such contracts;

 

(b)         During the fourth quarter of 2004, theCompany implemented, and plans to continue to enhance, its month-end closingprocedures, including reconciliations and controls over spreadsheets, andstandardized checklists to ensure such procedures are consistently andeffectively applied throughout the organization; and

 

(c)          The Company plans to enhance in 2005 thecommunication and distribution of its accounting policies and procedures anddevelopment of a process to more effectively accumulate and analyze informationrequired for financial statement footnote disclosures.

 

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8.               Income Tax Analysis—The Company’s plannedremediation measures are intended to address material weaknesses related to thecalculation of its provision for income taxes that have the potential ofmisstating the provision for income taxes and related balance sheet accounts infuture financial periods. The Company’s planned remediation measures includethe following:

 

(a)          The Company plans to hire and trainadditional experienced tax managers and supporting staff in 2005 to closelymonitor reporting from China and Japan, to assist in managing audits and tomonitor tax compliance in China and Japan;

 

(b)         During the first quarter of 2005, the Companyutilized outside consultants, other than the Company’s independent registeredpublic accounting firm, to assist the Company’s management, working under itssupervision and direction, in its analysis and calculation of its income taxprovision, and the Company plans to continue to utilize outside consultants,other than the Company’s independent registered public accounting firm, toassist the Company’s management, working under its supervision and direction,in its analysis of such matters in future periods; and

 

(c)          The Company plans to develop a comprehensiveprocess to accumulate and organize financial and tax data used in connectionwith income tax calculation and reporting.

 

9.               Utilization of Automated Controls—The Company’splanned remediation measures are intended to address a material weaknessrelated to the segregation of duties and user access to certain Oracle businessprocess applications that have the potential of misstating of various accountsin future financial periods. The Company’s planned remediation measures includethe following:

 

(a)          During the first quarter of 2005, the Companyoutsourced to a third-party expert the position of chief security officer to,among other duties, monitor access rights with respect to the Oracle system andmanage ongoing provisioning and changes;

 

(b)         The Company plans to improve utilization ofcurrent functionality and continue to upgrade and expand functionality of theOracle financial reporting system through utilization of additional modules toreduce manual procedures and the utilization of spreadsheets;

 

(c)          The Company plans to deploy the Oracle systemin Japan by the third quarter of 2005;

 

(d)         The Company is in the process of continuingto upgrade and implement additional Oracle modules to more effectively trackinventory and evaluate deferred costs; and

 

(e)          The Company plans to implement in 2005 morerobust controls over the release of costs to the income statement by betterutilizing the Oracle system.

 

*Interim Measures*. Management has not yet implemented all of the measures described initems 1 through 9 above and/or tested them. Nevertheless, management believesthose measures identified above as having been implemented, together with theother measures undertaken by the Company described below, all of which wereundertaken during the firstquarter of 2005 or subsequent to March 31, 2005 inconnection with the March 31, 2005 quarter-end reporting process, addressthe material weaknesses described in item 1 of “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2004 Form 10-K.  These other measures include the following:

 

•                  The Company promoted an individual within theCompany with relevant accounting experience, skills and knowledge to becomecontroller of China operations in April 2005.  This individual managed the first quarter2005 close process in China.

•                  The Company retained on an interim basisoutside consultants, other than the Company’s independent registered publicaccounting firm, with relevant accounting experience, skills and knowledge,working under the supervision and direction of the Company’s management, toassist with the March 31, 2005 quarter-end reporting process.

•      In connection with the 2004 year-endreporting process, the Company conducted an additional review of a substantialmajority of its revenue-generating contracts for compliance with revenuerecognition criteria. and continued this review during the first quarter of2005. As part of this review, the Company gathered and analyzed evidence ofdelivery and final acceptance.

•                  The Company performed the following reviewsof inventory-related matters: it reviewed consolidated revenue schedules fromthe first quarter of 2005 to determine the proper recording of cost of goodssold; it performed a roll-forward analysis of 

 

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inventory balances from December 31,2004 to March 31, 2005 and reviewed various supporting documentation; and itconducted physical inventory counts at selected locations.

•                  The Company conducted a review of theprocesses to record inventory reserves and a review of the manual procedures bywhich the Company tracks the cost of its products.

•                  The Company conducted a variety of manualreview procedures, such as an extensive review of journal entry postings intothe Oracle system and an extensive review of account reconciliations.

•                  The Company conducted a detailed andextensive review of the following matters: all non-routine transactions andinternal representations; financial statements, as well as certifications fromdecentralized locations, for accuracy and journal entries.

•                  The Company reviewed its reserves and relatedschedules and reported its findings to the Audit Committee.

 

***Material weakness described in item 2 of “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

 

*Remediation Initiatives*.   TheCompany’s failure to ensure that key management fully understood the nature andpotential significance of related parties and to ensure that a robust processfor the identification of related party transactions contributed to the Company’sfailure to maintain effective controls over the identification of andaccounting for related party relationships and related party transactions withthe Company. To remediate the material weakness described in item 2 of “Management’sReport on Internal Control Over Financial Reporting” in Item 9A of the 2004 Form 10-K,the Company has implemented or plans to implement the measures described below,and will continue to evaluate and may in the future implement additionalmeasures.

 

1.               The Company conducted an educational seminarwith the Company’s key management in March 2005 in which the Company’sinternal and outside legal counsel and members of the Audit Committee reviewedcertain key objectives of the Company’s Code of Conduct, including theidentification, recognition and disclosure of related party transactions.

 

2.               In the first quarter of 2005, the Companyexpanded the number of Company personnel required to certify to seniormanagement with respect to identification, recognition and disclosure ofrelated party transactions for SEC reporting purposes, and revised the Company’sinternal certification process concerning identification, recognition anddisclosure of related party transactions.

 

3.               The Company plans to continue to evaluate theCompany’s procedures to ensure the identification, recognition and disclosureof related party transactions.

 

4.               The Company plans to conduct periodictraining sessions with key managers and senior executives regarding the Code ofConduct, including the identification, recognition and disclosure of relatedparty transactions.

 

5.               The Company plans to provide key managers andsenior executives with access to legal and accounting personnel to enable suchmanagers and executives to more accurately and comprehensively comply with theCompany’s internal certification process for SEC reporting purposes.

 

*InterimMeasures.*                       Managementhas not yet implemented all of the measures described above and/or tested them.Nevertheless, management believes those measures identified above as havingbeen implemented, together with the other measures undertaken by the Companydescribed below, all of which were undertaken during the first quarter of 2005or subsequent to March 31, 2005 in connection with the March 31, 2005quarter-end reporting process are sufficient to address the material weaknessdescribed in item 2 of “Management’s Report on Internal Control Over FinancialReporting”  in Item 9A of the 2004 Form10 K.  These other measures include thefollowing:

 

•                  Management directly interviewed seniorexecutives regarding related party transactions.

 

•                  After receiving additional training onrelated party transactions, key managers and senior executives provided newcertifications regarding related party transactions.

 

***Material weakness described in item 3 of “Management’sReport on Internal Control Over Financial Reporting”*** ***in Item 9A of the 2004 Form 10-K***

 

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*Remediation Initiatives*.  Lack of clarity in roles and responsibilities in certain areas affectingthe Company’s financial reporting structure contributed to a material weaknessrelating to the monitoring of non-U.S. operations. To remediate this materialweakness, described in item 3 of “Management’s Report on Internal Control OverFinancial Reporting” in Item 9A of the 2004 Form 10-K, the Companyhas implemented or plans to implement the measures described under “—Materialweaknesses described in item 1 of ‘Management’s Report on Internal Control OverFinancial Reporting’—Remediation Measures—1. General plan for hiring andtraining of personnel” in Item 9A of the 2004 Form 10-K, as well asthose described below. The Company will continue to evaluate and may in thefuture implement additional measures.

 

1.               The Company streamlined the reportingstructure between all non-U.S. accounting functions and the comparable groupsin the corporate headquarters, including tax, treasury and financial planningand analysis groups, in early 2005 to provide for direct reporting to, andoversight by, the U.S. corporate headquarters.

 

2.               The Company plans to expand the size of theinternal audit group and the scope of the internal audit group’sresponsibilities to monitor non-U.S. operations through reviews and audits ofsuch locations.

 

3.               The Company’s chief financial officer, withassistance from senior financial staff and outside consultants, other than theCompany’s independent registered public accounting firm, has reviewed and willcontinue to review and adapt the overall design of the Company’s financialreporting structure, including the roles and responsibilities of eachfunctional group within the Company.

 

4.               The Company has implemented, and plans tocontinue to improve, a closing checklist to standardize its procedures forfinancial review to ensure that U.S. reviewers monitor financial informationfrom non-U.S. locations in a consistent manner, through such measures as use ofstandardized reporting packages and review procedures.

 

*InterimMeasures.*                       Managementhas not yet implemented all of the measures described above and/or tested them.Nevertheless, management believes those measures identified above as having beenimplemented, together with the other measures undertaken by the Companydescribed below, all of which were undertaken during the first quarter of 2005or subsequent to March 31, 2005 in connection with the March 31, 2005quarter-end reporting process, address the material weakness described in item3 of “Management’s Report on Internal Control Over Financial Reporting” in Item9A of the 2004 Form 10 K.  These othermeasures include the following:

 

•      The Company promoted an individual withinthe Company with relevant accounting experience, skills and knowledge to becomecontroller of China operations in April 2005. This individual managed the first quarter 2005 close process in China.

•      The Company’s Internal Audit staffperformed an additional review of invoices and cash disbursements in Japan.

•                  Senior financial staff in the Company’s U.S.headquarters did a thorough review of trial balances issued from non-U.S.locations.

•                  The Company utilized outside consultants,other than the Company’s independent registered public accounting firm, toassist the Company’s management, working under its supervision and direction,with the quarter-endreview of China operations.

•                  All non-routine transactions in non-U.S.locations were documented by staff in such non-U.S. locations and reviewed bysenior financial staff in the Company’s U.S. headquarters.

 

***Material weakness described in item 4 of “Management’sReport on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

 

*Remediation Initiatives*.     TheCompany’s failure to have sufficient personnel with knowledge, experience andtraining in the application of generally accepted accounting principlescommensurate with the Company’s financial reporting requirements contributed toa material weakness relating to the Company’s control environment. To remediatethis material weakness, described in item 4 of “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2004 Form 10-K,the Company has implemented or plans to implement the measures described under “—Materialweaknesses described in item 1 of ‘Management’s Report on Internal Control OverFinancial Reporting’—Remediation Measures—1. General plan for hiring andtraining of personnel” in Item 9A of the 2004 Form 10-K, as well asthose described below. The Company will continue to evaluate and may in thefuture implement additional measures.

 

1.               The Company streamlined the reportingstructure between all non-U.S. accounting functions and the comparable groupsin the corporate headquarters, including tax, treasury and financial planningand analysis groups, in early 2005 to provide for direct reporting to, andoversight by, the U.S. corporate headquarters.

 

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2.               The Company plans to expand the size of theinternal audit group and the scope of the internal audit group’sresponsibilities to monitor non-U.S. operations through reviews and audits ofsuch locations.

 

3.               The Company’s chief financial officer, withassistance from senior financial staff and outside consultants, other than theCompany’s independent registered public accounting firm, has reviewed and willcontinue to review and adapt the overall design of the Company’s financialreporting structure, including the roles and responsibilities of eachfunctional group within the Company.

 

4.               The Company has implemented, and plans tocontinue to improve, a closing checklist to standardize its procedures forfinancial review to ensure that U.S. reviewers monitor financial informationfrom non-U.S. locations in a consistent manner, through such measures as use ofstandardized reporting packages and review procedures.

 

*Interim Measures.       *Management has not yet implementedall of the measures described above and/or tested them. Nevertheless,management believes those measures identified above as having been implemented,together with the other measures undertaken by the Company described below, allof which were undertaken during the first quarter of 2005 or subsequent toMarch 31, 2005 in connection with the March 31, 2005 quarter-end reportingprocess, address the material weaknesses described in item 4 of “Management’sReport on Internal Control Over Financial Reporting” in Item 9A of the 2004Form 10 K.  These other measures includethe following:

 

**•****                 **The Company promoted an individual within theCompany with relevant accounting experience, skills and knowledge to becomecontroller of China operations in April 2005.  This individual managed the first quarter2005 close process in China.

•      The Company’s Internal Audit staffperformed an additional review of invoices and cash disbursements in Japan.

•      Senior financial staff in the Company’sU.S. headquarters did a thorough review of trial balances issued from non-U.S.locations.

•      The Company utilized outside consultants,other than the Company’s independent registered public accounting firm, toassist the Company’s management, working under its supervision and direction,with the quarter-end review of China operations.

•      All non-routine transactions in non-U.S.locations were documented by staff in such non-U.S. locations and reviewed bysenior financial staff in the Company’s U.S. headquarters.

 

***Control deficiencies not constitutingmaterial weaknesses***

 

Inaddition to the material weaknesses described in “Management’s Report onInternal Control Over Financial Reporting” in Item 9A of the 2004 Form 10-K,management has identified other deficiencies in internal control over financialreporting that did not constitute material weaknesses as of December 31,2004. The Company has implemented and/or plans to implement during 2005 variousmeasures to remediate these control deficiencies and has undertaken otherinterim measures to address these control deficiencies.

 

***Management’s Conclusions***

 

Managementbelieves the remediation measures described under “Management’s RemediationInitiatives and Interim Measures” above will strengthen the Company’s internalcontrol over financial reporting and remediate the material weaknessesidentified in “Management’s Report on Internal Control Over Financial Reporting”in Item 9A of the 2004 Form 10-K. However, management has not yet implemented all of these measures and/ortested them. Management has concluded that the interim measures described under“Management’s Remediation Initiatives and Interim Measures” above providereasonable assurance regarding the reliability of financial reporting and thepreparation of the Company’s financial statements included in this QuarterlyReport on Form 10-Q and has discussed its conclusions with theCompany’s Audit Committee.

 

TheCompany is committed to continuing to improve its internal control processesand will continue to diligently and vigorously review its disclosure controlsand procedures and its internal control over financial reporting in order toensure compliance with the requirements of Section 404 of theSarbanes-Oxley Act. However, any control system, regardless of how welldesigned, operated and evaluated, can provide only reasonable, not absolute,assurance that its objectives will be met. As management continues to evaluateand work to improve the Company’s internal control over financial reporting, itmay determine to take additional measures to address control deficiencies, andit may determine not to complete certain of the measures described under “Management’sRemediation Initiatives and Interim Measures” above.

 

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**Changes in Internal Control over Financial Reporting**

 

Thediscussion above under “Management’s Remediation Initiatives and InterimMeasures” describes the material planned and actual changes to the Company’sinternal control over financial reporting during the first quarter of 2005 andsubsequent to March 31, 2005 that materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

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**PART II****—OTHER INFORMATION**

 

**ITEM 1****—LEGAL PROCEEDINGS**

 

*SecuritiesClass Action Litigation*

 

On October 26, 2004,an alleged former shareholder of the Company filed a class action complaint inthe United States District Court for the District of Idaho against us and twoof our directors and/or officers, purporting to assert claims under the federalsecurities laws on behalf of a class of purchasers of the Company’s publiclytraded securities in the period from April 16, 2003 through September 20, 2004.  Among other things, the complaint refers toour disclosures as to “significant control deficiencies” related to revenuerecognition and as to the deferral of revenue recognition on a particulartransaction and the related lowering of our financial guidance.  The complaint further alleges that thedefendants previously made positive statements regarding our business andfinancial performance that were false and misleading because such statements,among other things, failed to disclose problems with our internal controls andrevenue recognition policies and procedures and failed to disclose that therevenue on the transaction at issue would need to be deferred, which allegedlycaused the price of our publicly traded securities to be artificially inflated.The complaint claims that the plaintiff and other class members were damaged asa result thereof, and seeks monetary recovery in their favor in an unspecifiedamount.

 

Four similar class actioncomplaints were later filed in the United States District Court for theNorthern District of California against us and several of our directors andofficers.  In both the Idaho court andthe California court, competing motions were filed for appointment of leadplaintiff and approval of lead plaintiff’s counsel, and in the California courtvarious motions for consolidation of actions were filed as well.  On March 15 and 16, 2005, theCalifornia court entered orders consolidating the cases pending in that court,appointing the lead plaintiff and approving the lead plaintiff’s counsel.  Pursuant to those orders, a consolidatedcomplaint is to be filed in that court within 60 days thereafter.  On April 6, 2005, the Idaho courtentered an order appointing the lead plaintiff and approving the lead plaintiff’scounsel.  On April 18, 2005, theparties filed a stipulation to transfer the Idaho case to the California court,and on April 21, 2005, the Idaho court approved the stipulation andordered the transfer of the Idaho case to the California court forconsolidation with the actions pending in that court.

 

This class action litigationis in its preliminary stages, and we cannot predict its outcome, as thelitigation process is inherently uncertain. However, we believe that the allegations and claims in this litigationare without merit and that we have valid defenses, and we intend to contestsuch allegations and claims and defend ourselves vigorously.  If the outcome of the litigation is adverseto us and if, in addition, we are required to pay significant monetary damages,our business would be significantly harmed. At a minimum, this litigation could result in substantial costs anddivert our management’s attention and resources, which could seriously harm ourbusiness.  As of March 31, 2005, noloss amount has been accrued because a loss is not considered probable orestimable.

 

*ShareholderDerivative Litigation*

 

On August 31 and September 2, 2004,respectively, two shareholder derivative actions were filed in the SuperiorCourt of California, Alameda County, by alleged shareholders of the Companypurporting to assert, on our behalf, claims of breach of fiduciary duty againstcertain of our current and former directors and officers, and also naming us asa nominal defendant.  The complaints inthese actions refer to our disclosures as to an Audit Committee investigationinto revenue recognition issues and as to “significant control deficiencies”related to revenue recognition.  Thecomplaints further allege that the individual defendants ignored problems withour accounting and internal control practices and procedures and breached theirfiduciary duties by failing to maintain adequate internal accounting controlsor to make good faith efforts to do so. Plaintiffs claim that such alleged breaches damaged the Company, andthey seek monetary recovery against the individual defendants and in favor ofthe Company, as well as equitable relief. In addition, plaintiffs claim that they should be excused from pre-suitdemand requirements based on allegations that our Board of Directors could nothave fairly evaluated such pre-suit demand, and thus that such demand wouldhave been futile.  On November 22, 2004,the Court entered an order consolidating the two actions and appointing leadplaintiffs’ counsel.

 

On November 23 and December 2, 2004,two related shareholder derivative actions were filed in the same court.  On January 13, 2005, the Courtconsolidated these two newer cases with the previously consolidated actions,and directed plaintiffs to prepare and file an amended consolidated complaint,which plaintiffs filed on January 31, 2005.  On March 17, 2005, we filed amotion, joined by other defendants, seeking dismissal of the consolidatedcomplaint for failure to adequately plead futility of the pre-suit demand.  On April 18, 2005, plaintiffs filedtheir opposition to that motion, and a hearing on the matter is currently setfor June 3, 2005.

 

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This derivative litigationis in its preliminary stages, and we cannot predict its outcome, as thelitigation process is inherently uncertain. However, we believe that plaintiffs’ allegations of “demand futility”are without merit, and we intend to contest those allegations vigorously.  At a minimum, this derivative litigationcould result in substantial costs and divert our management’s attention andresources, which could seriously harm our business.  As of March 31, 2005, no loss amount hasbeen accrued because a loss is not considered probable or estimable.

 

*IPOAllocation*

 

On October 31, 2001,a complaint was filed in United States District Court for the Southern Districtof New York against us, some of our directors and officers and variousunderwriters for our initial public offering. Substantially similar actions were filed concerning the initial publicofferings for more than 300 different issuers, and the cases were coordinatedas In re Initial Public Offering Securities Litigation, 21 MC 92.  In April 2002, a consolidated amendedcomplaint was filed in the matter against us, captioned In re UTStarcom,Initial Public Offering Securities Litigation, Civil Action No. 01-CV-9604.  Plaintiffs allege violations of theSecurities Act of 1933 and the Securities Exchange Act of 1934 throughundisclosed improper underwriting practices concerning the allocation of IPOshares in exchange for excessive brokerage commissions, agreements to purchaseshares at higher prices in the aftermarket and misleading analyst reports.  Plaintiffs seek unspecified damages on behalfof a purported class of purchasers of our common stock between March 2, 2000and December 6, 2000.  Ourdirectors and officers have been dismissed without prejudice pursuant to astipulation.  On February 19, 2003,the Court granted in part and denied in part a motion to dismiss brought bydefendants including us.  The orderdismisses all claims against us except for a claim brought under Section 11of the Securities Act of 1933, which alleges that the registration statementfiled in accordance with the IPO was misleading.  In June 2004, a stipulation ofsettlement and release of claims against the issuer defendants, including us,was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release allclaims against the participating defendants (including us).  In exchange for this dismissal, D&Oinsurance carriers would agree to guarantee a recovery by the plaintiffs fromthe underwriter defendants of at least $1 billion, and the issuerdefendants would agree to an assignment or surrender to the plaintiffs ofcertain claims the issuer defendants may have against the underwriters.  The settlement is subject to a number ofconditions, including court approval.  Ifthe settlement does not occur, and litigation against us continues, we believewe have valid defenses and we intend to defend the case vigorously.  The total amount of the loss associated withthe above litigation is not determinable at this time.  Therefore we are unable to currently estimatethe loss, if any, associated with the litigation.

 

*StarentPatent Infringement Litigation*

 

We have sued StarentNetworks Corporation (“Starent”) for patent infringement in the U.S. DistrictCourt for the Northern District of California. On March 22, 2004, we filed our Complaint.  On June 3, 2004, we served ourComplaint on Starent.  On July 30, 2004,Starent filed and served its answer and counterclaims.  On August 30, 2004, we served andfiled our Amended Complaint.  In ourAmended Complaint, we assert that Starent infringes a UTStarcom patent throughthe manufacture, use, offer for sale, and sale of Starent’s ST-16Intelligent Mobile Gateway.  We seek, interalia, compensatory damages and injunctive relief.  Starent filed its answer to the AmendedComplaint and counterclaims on September 17, 2004.  In its answer and counterclaims, Starentdenies our allegations and seeks a declaration that the patent-in-suit is notinfringed, is invalid and is unenforceable. The Court held an initial case management conference on November 2, 2004and scheduled a hearing to construe the claims of the patent-in-suit for June 30, 2005.  At that time the Court will hold an additionalcase management conference to schedule a date for trial.  On February 17, 2005, we filed amotion for a preliminary injunction against Starent’s use, sale, and offer forsale of products having the infringing feature. A hearing on our motion is set for May 11, 2005.  Although we cannot reliably predict theoutcome of this litigation, we believe that any adverse judgment on Starent’scounterclaims will not have a material adverse effect on the business,financial condition, or results of our operations.

 

On February16, 2005, we filed a second suit against Starent for patent infringement in theU.S. District Court for the Northern District of California.  On May 6, 2005, we served the Complaint onStarent.  In the Complaint, we assertthat Starent infringes one of our patents through Starent’s development andtesting of a software upgrade for its customer’s installed ST-16 IntelligentMobile Gateways.  We seek, inter alia,declaratory and injunctive relief.  TheCourt has set a case management conference for August 19, 2005.  This lawsuit is in its initial stages andStarent has not yet answered, counterclaimed, or otherwise filed a response toour Complaint.

 

*FennerInvestments Patent Infringement Litigation*

 

On January 6, 2005,Fenner Investments, Ltd. filed suit against us and co-defendants JuniperNetworks, Inc., Nokia, Inc., Nortel Networks Corp., LucentTechnologies, Inc., and Cisco Systems, Inc. in the U.S. DistrictCourt for the Eastern District of Texas. The suit alleges that unspecified productsand services infringe two Fenner patents and seeks compensatory and injunctiverelief. On March 1, 2005, we filed a motion to dismiss the complaintdue to improper venue. A hearing on our motion and a scheduling conference isset for May 16, 2005.  This lawsuitis in its initial stage and it is not possible to reliably predict the outcomeor any relief that could be awarded, as the litigation process is inherentlyuncertain. We intend to contest the allegations and claims and defend ourselvesvigorously. If the outcome of the litigation is adverse to us and if, inaddition, we are enjoined or required to pay significant monetary damages, ourbusiness may be harmed. At a minimum, this litigation could result insubstantial costs and divert our management’s attention and resources, whichcould harm our business.

 

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*Other*

 

On August 19, 2004,we received a letter from the new management team of Hyundai Syscomm, Inc.(“HSI”) stating that they consider the Asset Purchase Agreement, dated as of February 26, 2004,among HSI, UTSI, Dr. Seong-Ik Jang and 3R Inc. (the ”APA”), and thevarious ancillary agreements entered into in connection with the closingrelated to the APA on April 27, 2004, to be null and void due tounfulfillment of condition precedents and material breach of terms of suchagreements.  Such condition precedentsand material breach of terms were not specified in such letter from HSI.  In addition, HSI has made allegations andarguments before Korean governmental agencies and to the Korean press allegingthat the technology that was purchased by us pursuant to the APA has beenexported outside of Korea.  We believenone of such technology has been exported by us from Korea to any foreigncountry.  In addition, we believe that wehave materially complied with all provisions of the APA and the ancillaryagreements and HSI cannot void or nullify such agreements.  We have taken, and will continue to take,appropriate legal actions to fully enforce our rights under the APA and theancillary agreements.  We believe thatthis dispute with HSI would not have a material adverse effect on our financialcondition, results of operations or cash flow.

 

We are a party to otherlitigation matters and claims that are normal in the course of operations, andwhile the results of such litigation matters and claims cannot be predictedwith certainty, we believe that the final outcome of such matters will not havea material adverse impact on our financial position or results of operations.

 

In the future we may subjectto other lawsuits.  Any litigation, evenif not successful against us, could result in substantial costs and divertmanagement’s attention and other resources away from our business operations.

 

**ITEM 2****—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

 

None

 

**ITEM 3****—DEFAULTS UPON SENIOR SECURITIES**

 

None

 

**ITEM 4****—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

None

 

**ITEM 5****—OTHER INFORMATION**

 

None

 

**ITEM 6****—EXHIBITS**

 
| **Exhibit  Number** | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                             |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                          |
| 31.1                |       | Certification  of the Chief Executive Officer pursuant to Rule 13a-14(a) or  Rule 15d-14(a) promulgated under the Securities Exchange Act  of 1934, as amended. |
| 31.2                |       | Certification  of the Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) promulgated  under the Securities Exchange Act of 1934, as amended.  |
| 32.1                |       | Certifications of the  Chief Executive Officer and Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                         |

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|                    | UTSTARCOM, INC. |                                                    |   |
|-------------------------|-----------------|---------------------------------------------------------|--------|
| Date: May 10, 2005 | By:             | /s/ Hong Liang Lu                                       |   |   |   |
|                    |            | Hong Liang Lu                                           |   |   |
|                    |            | *President,  Chief Executive Officer and Director*      |   |
|                    |            | *(Principal  Executive Officer)*                        |   |   |
|                    |            | * *                                                |   |   |
| Date: May 10, 2005 | By:             | /s/ Michael J. Sophie                                   |   |   |   |
|                    |            | Michael J. Sophie                                       |   |   |
|                    |            | *Senior  Vice President of Finance and Chief Financial* |   |
|                    |            | *Officer*                                               |   |   |
|                    |            | *(Principal  Financial Officer)*                        |   |   |
|                         |                 |                                                         |        |  |  |  |

 

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